1981 was an auspicious year for technology. IBM released its first PC, powered by software known as “MS-DOS” that was created by a little startup software company named Microsoft, and Congress enacted the first version of the “Credit for increasing research activities,” better known as the “R&D tax credit.” Technology has advanced a lot since then, but from a tax standpoint, the frequent changes in the R&D credit and its related regulations mean that it’s always worth a fresh review of your business’ software and technology investments to determine if they include research and development (R&D) costs that may qualify as eligible expenses under the credit’s rules.
The frequent changes in the R&D credit and its related regulations mean that it’s always worth a fresh review of your business’ software and technology investments.
R&D tax credit: The basics
Costs may qualify for the R&D tax credit when they relate to an effort within the business that:
- Uses hard science, including engineering or computer science.
- Develops a new or improved product or process, including software programs and technology platforms.
- Uses a process of experimentation, which generally involves testing, to eliminate technological uncertainty.
Many businesses overlook eligibility for the R&D tax credit because, unless they’re developing something never done before, they might not think of software development efforts as potentially qualified for the credit. They might not consider how those efforts are still resolving technological uncertainty in some capacity. If the boss, the customer, or the marketplace demands something, you launch an initiative that you’ll do what it takes to meet that demand. However, you may be considerably uncertain as to how you will provide it. It’s the ongoing iterative process of researching, coding, QA testing, and releasing products that meet the credit’s criteria.
More and more SaaS (software as a service) companies are incurring eligible expenses because of the demand for real-time, interactive ways for users to access and manage highly sensitive customer information through secure connections. Insurance companies are developing specific solutions tailored to state and local rules. Healthcare providers are creating customer portals to connect patients and doctors more directly and to more effectively make data-driven decisions than ever before. Regardless of the industry, costs for system architecture, code development, interface design, and testing are the types of technology investments that may qualify for the R&D tax credit.
Internal use software
In some cases, companies are also undergoing significant development projects to improve internal systems that are used for general and administrative use, such as human resources management, financial and accounting systems, and other back-office type activities. Those costs that businesses incur to create their own software for internal use may also qualify for the credit, but such efforts need to meet three criteria in addition to the basic R&D tax credit rules listed above. The effort must:
- Commit substantial resources to the software development and involve significant economic risk due to the technical uncertainties.
- Create software to meet a need that cannot be met by software already commercially available for purchase, lease, or license without significant modifications.
- Result in innovative software that delivers a significant reduction in cost, enhancement of speed, or measurable improvement for the business.
What are the eligible expenses?
Identifying and properly documenting the R&D costs that qualify for the credit is a key part of successfully claiming and sustaining this tax benefit. One critical overarching requirement is that the costs must be incurred in the United States. Costs attributable to any research performed outside of the United States might still be deductible business expenses, but they must be excluded from the calculation of the R&D tax credit. Eligible expenses include:
- W-2 wages for work performed in the United States
- U.S.-based contractor costs, temporary employees, staff augmentations and, in some cases, professional technology consultants
- Cloud-computing costs, including virtual servers used to host development, quality assurance, and user acceptance testing
- Supplies used, if any, during the development effort
Typically, a business qualifies to claim the credit when it retains both the financial risk of loss if the research fails and certain rights to the finished product. When contracts are involved, careful analysis of the contract terms may be required to determine which party has the right to claim the R&D tax credit for the related expenses.
Calculating and documenting the R&D tax credit
One of the most challenging aspects of properly calculating the R&D tax credit is accurately capturing eligible expenses and documenting activities. The calculation itself involves comparing current year expenses to a ratio of similar expenses incurred during the three preceding years. After a little more math, the resulting credit is generally 5-8% of current year expenses.
Documenting the activities performed is as important to sustaining the credit as identifying the eligible expenses is to calculate it. If picked for IRS examination, the IRS will expect contemporaneous support of the work performed by your team — capturing and maintaining select information annually is key.
Don’t make assumptions
The first step to qualifying for the R&D tax credit is understanding that it’s not just for Microsoft and Google. If you develop new or improved products, processes, systems, and platforms or portals, you may incur eligible expenses. To learn more about the credit and what activities of your business might qualify, please contact one of our experts.