By Heidi Henderson.
If your clients are in the software development business, you might be happy to know that federal research and development (R&D) tax credits (designed to spur technology innovation in the United States) can reimburse them for the development of new products, processes or inventions. ; the credits can earn them a significant percentage for qualified research activities and qualified research expenditures. And more than 40 US states also offer a state-level tax credit. To qualify for the credit, your customer’s software need not be new to the world, only new to their company.
But before they file for R&D tax credits with the IRS, what do you need to know about them? First, the IRS classifies all software into one of two categories: 1) software for external or third-party use and 2) software for internal use. Each is judged according to different criteria.
External software criteria
A great example of external software is Microsoft. External software is intended for sale, rental or license to customers. The IRS will accept the credit if the research passes this four-part test:
- This must be technological in nature: The activity must be based on hard sciences, such as engineering, physics or computer science.
- It must involve a new or improved business component: Your client must demonstrate that he intends to develop a new or improved product or process, and not to make a simple cosmetic change.
- It must involve the process of experimentation: They must evaluate the alternatives by modelling, simulation, testing or other methods.
- it must pass technical uncertainty test: They must eliminate technical uncertainty through your research. They must explain how they endeavored to achieve the desired result and how they achieved this objective.
The IRS applies the four-part test to each business component, i.e. each software version or module developed. Here are some examples of software applications for external use that may qualify:
- document management systems
- educational software
- marketing software
Internal software criteria
Internal-use software is designed to support a business internally. It can be used for administrative, financial or HR management purposes or to provide support services within a company. Companies develop software for internal use, based on their own platform, in order to be more operationally efficient or to avoid paying fees to a third-party supplier.
However, in-house software must meet stricter requirements. It must be very innovative, and there can be nothing like it on the market. (Software for external use does not have this requirement, as it is based on an original platform.)
Software for internal use must pass not only the four-part research test above, but also an enhanced three-part test:
- The software must be very innovative.
- Its development must introduce significant economic risk.
- A similar product must not be commercially available.
To determine the presence of a significant economic risk, internal software must pass an additional two-part test.
- Your client’s business needs to commit significant resources.
- Substantial uncertainty must be involved. Can the R&D investment be recovered within a reasonable time?
Here are some examples of R&D activities that the IRS considers eligible for the credit:
- Alpha/beta testing
- Design and testing of applications and platforms
- Coding, programming, testing (e.g. for functional, integration or user interface purposes)
- Cloud computing development activities
- New architectures, new algorithms or new database management techniques
- Development of software and hardware products to foster communication and interaction
- Design of specialized technologies (such as for image processing, artificial intelligence or voice recognition)
- System software development (e.g. operating systems or compilers)
Eligible research expenses
Qualified Research Expenses (QRE) are expenses deemed by the IRS to be acceptable for credit. They include:
- salaries of employees who carry out R&D
- supplies used during the R&D process
- part of what an entrepreneur spends on R&D activity.
Expenses may include cloud computing costs and costs associated with offsite servers.
It is important to note that the R&D tax credit is above all a salary driven credit. The lion’s share of R&D expenditure comes from the cost of compensation for eligible employees and consultants. However, for the purposes of claiming the R&D tax credit, all employees and consultants must be based in the United States, and not in India or another outsourcing location.
A few other points:
- Funded research is disqualified.
- If your client is also claiming the employee retention credit, this may reduce the amount of credit they may be entitled to, as the ERC reduces payroll costs.
- Additionally, they must own the intellectual property rights to the platform they are building.
Above all, documentation is key. Your client must have evidence to defend the credit and back them up when they go to file. They should:
- Follow the list of projects or revisions. Each version of the release would be a new project.
- Keep a list of projects and what their staff are working on.
- Have a time tracker in place.
- Include employee titles.
Potentially eligible R&D job titles could include:
- Director of Software Engineering
- Senior Technical Managers
- Software analyst
- Software developers
- Software integration engineers
Your client can bank their tax savings to fund new projects
Less than a third of businesses eligible for the credit even know it exists, so two-thirds lose out. If your client’s activities and expenses qualify and they have kept diligent documentation, they can realize substantial tax savings that they can then reinvest in their business, so they can undertake even more research. and earn additional R&D tax credits! It’s a virtuous circle.
Heidi Henderson is an executive vice president at Engineered Tax Services and a national tax consultant specializing in federal tax incentives. An active real estate investor, she holds a bachelor’s and master’s degree from the University of Phoenix. If you have any questions, you can email him at: [email protected]