Authored by: Wendy Landrum
To increase market share and remain competitive in an environment of constant change, it is critical that software and technology companies continuously engage in new product development. While the expense of such development can seem prohibitive, the research and development (R&D) tax credit can help alleviate those costs. Companies that qualify can claim wages, supplies and contract research costs associated with R&D projects and activities.
Generally, in order to qualify for the R&D credit, activities must meet each of the following requirements:
- Must be technological in nature. The activity must be based on the principles of a hard science such as engineering or computer science.
- Must be for a permitted purpose. The activity must involve the creation of a new or improved level of function, performance, reliability, quality, durability or cost reduction.
- Must involve the elimination of uncertainty. The activity must explore what was not known at the start of the project as it relates to capability, methodology and design.
- Must involve a process of experimentation. Substantially all of the activities must include elements of experimentation including evaluating one or more alternatives, performing testing or modeling, examining and analyzing hypotheses or refining or abandoning hypotheses.
Special considerations for software development costs
Software development is subject to the four-part test above, if the project was developed for any of the following conditions:
- For use in an activity that is qualified research
- In a production process that is qualified research
- As a new or improved package of computer software and hardware together as a single product, of which the software is an integral part, used directly in providing services to customers
- For use in providing computer services to customers
- For use in providing noncomputer services designed to provide customers a new feature
New final regulations for internal use software
On Oct. 6, 2016, the IRS released final regulations providing guidance on the application of the R&D credit with respect to internal use software (IUS). The final regulations are prospective and apply to taxable years beginning on or after Oct. 4, 2016.
IUS is software used for “general and administrative” functions that facilitate or support the conduct of the taxpayer’s trade or business. General and administrative functions are limited to “back-office functions,” such as financial and human resource management and support services functions. Software is not developed for internal use if it is commercially sold, leased, or licensed or enables a taxpayer to interact with third parties or to allow third parties to initiate functions or review data.
Dual function software, used both for general and administrative functions and to enable interaction with third parties or allow third parties to initiate functions or review data, is presumed to be IUS. However, if subsets of dual function software can be identified, the expenditures related to the third-party subset may be eligible for the research credit. A safe harbor may be utilized for dual function software, but is not required, allowing 25 percent of the qualified research expenditures to be included in credit calculation as long as the use of the dual function subset by third parties is reasonably anticipated to be at least 10 percent.
High threshold of innovation test
The taxpayer must meet the following three criteria, in addition to the four-part test described above, in order for IUS to be eligible for the research credit:
- Must be innovative
- Involve significant economic risk
- Not commercially available for use
Identifying an R&D opportunity
In order to determine the eligibility and potential benefit with regard to the R&D credit, companies should consider the actual size, spend and payroll of software and IT departments, focusing on the actual applications and programmer roles (versus technical support and network employees).
Examples of qualified research activities related to software development may include the following:
- Designing and developing new products and/or product enhancements
- Developing product specifications or requirements
- Designing and integrating applications and technologies
- Developing new or improved technologies (e.g., new algorithms or methodologies)
- Designing, developing and testing client-specific applications
- Designing and developing software architecture
- Programming software source code
- Conducting functional and/or technical testing to validate design
- Compiling and testing source code
In the 2015 tax extenders package, Protecting Americans from Tax Hikes (PATH) Act of 2015, the R&D credit was made permanent removing the uncertainty around the ability to claim the credit in future years. A new provision also allows businesses with less than $50 million in gross receipts to offset the R&D credit against alternative minimum tax, beginning in 2016.
The most important change for the software and technology industry with a high number of startup companies, a new provision, also beginning in 2016, allows certain small businesses with less than $5 million in gross receipts to offset the R&D credit against payroll taxes. This benefits startup companies that do not yet have income tax liability to get cash flow savings from investments in R&D.
Take advantage of R&D credit opportunities
Baker Tilly has an experienced team of R&D professionals who will partner with you to develop an efficient and cost-effective approach for identifying and documenting eligible R&D activities and costs. We have assisted many clients in a variety of industries in identifying, documenting and sustaining R&D tax incentives through a comprehensive understanding of their business operations.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.