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 and so has the opportunity for companies to benefit from the favorable tax treatment of the related spend. Changes in the R&D credit and the introduction of new guidance defining software development make it essential to regularly review your business’s software and technology investments to determine whether you have costs that may be eligible research and development (R&D) expenses.
R&D tax credit considerations for software development
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 their software development efforts could potentially qualify for the credit. They might not consider how those efforts are still resolving technological uncertainty in different capacities. If the boss, the customer, or the marketplace demands something, you launch an initiative and propose a solution to meet that demand. However, you may have various areas of uncertainty as to how you will achieve it. It’s the ongoing iterative process of researching, coding, QA testing, and releasing products that meet the credit’s criteria.
SaaS (software as a service) companies are increasingly 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 using AI to more effectively make data-driven decisions. 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.
When does internal-use software qualify for the R&D tax credit?
When companies undertake significant development projects to improve internal systems that are used for general and administrative purposes, such as human resources management, financial and accounting systems, and other back-office type activities, those projects are considered internal-use software for the R&D credit. Those costs 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 can’t 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.
Capturing eligible expenses, documenting activities, and calculating the R&D tax credit
One of the most challenging aspects of the R&D tax credit can be accurately capturing eligible expenses and documenting R&D activities. The calculation itself typically 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 qualified research expenses.
Documenting the activities performed is as important to sustaining the credit, as is identifying the eligible expenses for the calculation. 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.
Key takeaways: Your software and technology expenses may qualify
- The first step to qualifying for the R&D tax credit is understanding that it’s not just for large technology companies.
- 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 whether your business might qualify, please contact one of our experts.
