Don’t overlook these tax-saving opportunities: Maximizing the R&D credit and the DPAD to lower your tax burden
There are a number of incentive programs, tax credits, and tax deductions available for technology companies. A trusted tax advisor can help you explore and identify opportunities to reduce your tax burden at the local, state, and federal levels. Sound financial reporting and documentation is vital for qualifying for any incentive program, tax credit, or tax deduction. Two key tax-reducing opportunities for technology companies are the research and development (R&D) tax credit and the domestic production activities deduction (DPAD).
R&D tax credit
The R&D credit exists to encourage companies to create new products and innovative technological solutions. It’s applicable to companies who use domestic-based software engineers, developers, and programmers, among others; you typically recoup about 5 to 7 cents for every dollar you invest, which directly reduces your tax bill.
If your business is in its early stages and operating at a loss, you may not be considering the R&D credit – but you should, especially since R&D expenses can be significant in the startup years. If you invest in claiming the credit early in your company’s life cycle, you can carry it over, up to 20 years, to taxable income years. In some cases, your business may be eligible to file an amended return and claim the credit for prior open tax years — meaning more money to help grow your business.
R&D credit specialists can help determine if you qualify for the credit and how to best capture and document the activities and expenses at both the federal and state levels.
Domestic production activities deduction (DPAD)
The DPAD, also called the Section 199 Deduction, provides a tax deduction generally equal to 9 percent of a company’s net income associated with qualified domestic production activities. This is often an overlooked deduction in the technology industry since it is mistakenly considered a manufacturing-only opportunity. However, the benefit is also available to producers of computer software, with some limitations related to how the software is delivered to, or used by, customers.
To qualify for the DPAD, property for sale must be “substantially” manufactured, produced, grown, or extracted in the United States. Domestic production gross receipts (DPGR) include receipts derived from the sale, lease, license, rental, exchange or other disposition of qualified property produced in the U.S. but do not include income related to services provided to end-users.
For example, software developed by a bank for online banking purposes, and the related customer fees, would be considered service income because the customer is not purchasing the software. Instead, the customer is paying for a service that is delivered by use of the online banking software.
On the other hand, software developed and sold to customers for their own internal bookkeeping purposes could qualify, as it most likely would relate to the sale or license of software, instead of the sale of a service. Therefore, careful analysis of the receipts related to software is required to determine whether the software is offered as a service, or if the software is truly licensed or sold.
As with other tax benefits, the DPAD calculation is complex and may be scrutinized by the IRS, but it can also be a significant benefit to taxpayers as they look to reduce their overall tax burdens. With proper planning and consultation, you can develop an approach to maximize the benefit while managing risk.
To qualify for an R&D tax credit, a company must:
- Develop a new or improved product or process. Remember, it doesn’t have to be new to the world — just your organization.
- Establish that the product or process contains technical uncertainty that necessitates experimentation based on hard science to resolve that uncertainty.
- Have activities based in the United States. The general rule is this: if you have U.S.-based activities involving engineers or technical specialists working in the hard sciences, you likely qualify for the R&D credit. Bear risk.
- Generally speaking, if a customer is paying you to develop a new product or the research is fully funded by a government grant, your company bears no financial risk. This type of activity does not qualify for the R&D credit.