Software development firms are textbook candidates for claiming the Research and Development (R&D) tax credit because of their significant investment in development and engineering as well as the highly technical nature of their design work. In fact, many of the day-to-day activities undertaken by software developers qualify for the credit due to their systematic and iterative nature. This type of work is what the framers of the credit aimed to incentivize during the first days of the R&D Credit in the 1980’s and it is doubly more important in current times given the sharp rise in global competition and innovation.
What Are R&D Tax Credits for Software Development Firms?
The R&D Credit, officially named the Credit for Increasing Research Activities, and found in Section 41 of the Internal Revenue Code, is a non-refundable incentive put into place by Congress to reward American businesses conducting R&D in the U.S. The credit follows a four-part test, consisting of the following criteria for a company’s activities:
- Related to the development of a new or improved business component, i.e. a product, process, formula, invention, technique, or software
- Undertaken to overcome technical uncertainty about the design of the business component(s) in question
- Rooted in a hard science such as physics, biology, chemistry, engineering, or computer science
- Follow a process of experimentation, even as simple as systematic trial-and-error
In the world of software development, qualified activities can take place in a multitude of projects, ranging from minor functionality improvements all the way to new clean-sheet designs.
The credit can be claimed for the following types of expenses tied to qualifying activities:
- Wages of employees conducting, directly supervising, or directly supporting development activities
- Payments to contractors for development or testing work
- Costs of computer rental or leasing, including cloud computing
The R&D Credit can also take into account materials used or consumed in the R&D, but this usually doesn’t apply to software developers.
Why R&D Tax Credits Are Critical for Software Development Firms
Software development firms should consider the R&D Credit an indispensable part of their toolkits for a variety of reasons:
- Reduced tax liability – the Section 41 credit is a dollar-for-dollar reduction in tax liability. It can therefore reduce a software firm’s tax bill if filed on a current-year return or can result in a refund check for prior-year claims on amended returns.
- Increased cash flow – with the savings provided by the R&D credit, a software developer can reinvest in other areas of its operations, such as hiring additional employees, acquiring new equipment, upgrading existing infrastructure, or paying off debts.
- Competitive edge – software developers claiming the R&D credit can undertake projects previously determined to be too risky or capital-intensive, thereby accelerating go-to-market timeframes.
- Funding diversification – given that many software developers tend to be newer companies with robust expansion plans, the R&D credit offers a great way for them to gain necessary funding that avoids or minimizes the need to pay interest on loans or give up equity to investors.
Even unprofitable start-ups can take advantage of the credit, given the provision allowing companies with under $5 million in gross receipts and less than five years of gross receipts to claim a modified credit that offsets payroll tax liability.
Regardless of the size of your software development business, there are many compelling reasons to claim the R&D credit.
Which Software Development Firms Qualify for R&D Tax Credits?
Due to the highly iterative and systematic nature of software design, as well as an available credit variant for start-ups, software developers of all sizes can take advantage of the Section 41 credit. Moreover, developers can qualify for a wide range of activities:
- Creating off-the-shelf or downloadable software, from MVP to fully developed solutions
- Developing firmware used in electronic devices
- Providing SaaS for specific applications
- Creating cloud-based platforms
- Integrating new or improved software within existing code or applications
- Designing phone or tablet apps
- Writing custom software
- Creating internal-use software not meant to be externally sold or licensed
- Designing or improving APIs
- Developing improvements or functional updates to existing software
Within all the above activities, it’s not just writing code that qualifies. Most of the development process, from initial whiteboard conceptualization, to coding, compiling, testing, and iteratively improving software, can qualify for the credit. Moreover, direct supervision of the R&D by executives and managers can qualify, as can direct support performed by lower-level employees.
Despite the wide range of potentially qualifying activities and projects, we hear the following myths all the time:
- My company doesn’t do R&D. Many businesses believe that only the most cutting-edge, experimental work that results in something new to the world qualifies. However, any application of the principles of software counts toward eligibility, meaning the steps taken to improve existing technologies or to solve customer problems through scientific principles (hypothesize, test, analyze) will generally lead to eligibility for the credit.
- We don’t qualify because my company does not license our clients’ software. This myth is prevalent because many developers assume if they don’t have the license for the products their clients use, they do not qualify. However, as long as you retain the rights to what you discovered during the research, and bore economic risk during those activities, you are eligible to claim the credit.
- I can’t claim the R&D Credit since I have already been paid for my work. If your company is paid based on its service, you qualify for the R&D Credit. Eligibility for the R&D credit hinges upon the activities and projects your company undertakes, not on whether you are compensated.
- The credit isn’t worth my return on investment. Section 41 is the biggest tax break a business can claim and can also be taken alongside other credits such as the Work Opportunity Tax Credit. We’ve helped software developers secure refunds of six to seven figures for their day-to-day activities, many of whom continue to claim the credit year after year.
- The R&D credit is only for large companies. There is no provision barring small- or mid-sized companies from claiming Section 41 and no single tax incentive comes close to the value this credit can give to software developers. In fact, Section 41 provides for a separate version of the credit for start-ups not yet generating income tax liability.
How Software Firms Can Claim R&D Tax Credits: A Step-by-Step Guide
Claiming the R&D Credit is a complex and multipart process that is most effectively accomplished with the help of an experienced advisor:
Step 1 – Generating Project List
Developers should first create a list of every project with potential qualified activities. These can range from improvements to existing products all the way to brand-new software. Qualifying projects do not need to achieve commercial success, or even go past the concept development stage, as long as they relate to a product or service that is ultimately intended to be marketed (or employed in-house, in the case of internal-use software).
Step 2 – Identifying Qualified Activities
Claimants must determine which qualified activities occurred in each project. These include conceptualizing, architecting, writing, testing, or iteratively modifying code. The activities can occur in a design meeting, during a messenger chat, or at a software engineer’s workstation.
Step 3 – Compiling Associated Costs
Expenses for the credit is based on include wages, contractor costs, and computer rental/lease expenses. To ensure these are claimed per IRS guidelines, developers must tie them to qualifying activities within qualified projects via documentation, or testimony where needed.
Step 4 – Gathering Applicable Documentation
While there is not a set documentation standard for R&D Credit claims, taxpayers must utilize what they generate on a daily basis to tie in projects, activities, and costs. Typically, software developers generate scopes of work, meeting notes/recap emails, code, employee timesheets, testing reports, bug lists, messenger chat logs, approval forms, and contractor/vendor invoices during their development work.
Step 5 – Complete Form 6765 and Associated Schedules
Form 6765, filed with a claimant’s corporate tax return, is the reporting mechanism for the R&D Credit. It requires taxpayers to not only show the expenses contributing to the credit and the calculation methodology, but also the business components the expenses are tied to, as well as the nature of the development work in each one.
Frequently Asked Questions (FAQs) for Software Development Firms
What is the potential value of an R&D credit claim?
Due to the complexity of the R&D Credit calculation, there isn’t a set percentage of expenses that translates to a tax credit – however, most companies will see up to 8 cents of credit for every dollar of qualified expense. Thus, a software developer with $500,000 of R&D expense could see $40,000 in credits. In addition, over 40 states have some form of R&D tax credit that can add to your benefit.
What types of projects qualify?
Any project that requires some form of software design, even if it’s just architecting a concept that was intended to go to market but never does, can qualify. Likewise, even minor improvements to existing software can qualify if a process of iterative trial-and-error was required to develop them. It doesn’t matter if the knowledge discovered isn’t new to the world. It just needs to be new to your business.
Which costs are taken into account in the R&D credit calculation?
The R&D credit calculation for software developers is based on wages paid to employees for qualified activities, amounts paid to contractors who conduct or assist in the research, and computer rental/leasing expenses, which can include cloud computing spend.
Can pre-revenue start-ups claim the R&D Credit?
Yes – in fact, there is a special variant of the Section 41 R&D Credit that allows newer companies under $5 million in gross receipts and five years with gross receipts to claim it. Since many start-ups don’t generate enough taxable income to have income tax liability, this version of the credit offsets payroll tax, so your business needs to at least have this type of liability for the credit to provide benefit.
What documentation is required for a claim?
As there is not a specific documentation standard set out in R&D Credit rules, businesses can rely on what they generate during their daily course of business. Most software developers we’ve worked with have some combination of meeting notes, emails, or messenger logs to document their concept development efforts, as well as iterations of code, bug lists, testing reports, or approval forms to show the design and testing process. Regardless of how little or how much documentation you create, an experienced advisor will be able to navigate this aspect of the claim to put you in the best position possible.
Due to the various facets and nuances inherent to R&D credit qualification, quantification, and substantiation, software developers should work with a reputable and experienced provider to maximize the success of their credit claims. At alliant, we’ve helped thousands of software developers claim this incentive since 2002 and would be happy to determine your company’s eligibility with a gratis assessment. You can schedule time with an expert here or dial us directly at 844.524.0077 to explore more.
