The Credit for Increasing Research Activities (also known as the R&D credit) is a nonrefundable, dollar-for-dollar federal tax credit primarily designed to stimulate research and development activity. The credit is expansive and covers many different qualifying activities; however, business owners often overlook the opportunities as they may be uncertain as to whether or not they qualify. While the software industry is perhaps one of the more common industries taking advantage of the credit, it is important to understand the expansive nature of the credit and avoid missed opportunities. The calculation of the credit is complex, but it generally consists of a credit for 20% of qualified research expenses (QREs) for the taxable year over a base amount. Note that this credit is now also available to offset against payroll taxes for businesses that have $5 million or less in gross receipts and meet certain other criteria. This now allows businesses to benefit from the credit even if they have no taxable income during the development years.
Understanding the Criteria
It is important to understand the IRS’s definition of what constitutes “qualified research” in order to receive the credit. For expenses to be qualified, the IRS requires that the related research satisfy four criteria:
- Technical in Nature: the research must rely on the principals of engineering, physics, biology, or computer science.
- Permitted Purpose: the research must result in a new product or improved product process, function, performance, reliability, quality, or significant reduction in cost.
- Elimination of Uncertainty: research is intended to eliminate uncertainty concerning the development or improvement of a product or process.
- Process of Experimentation: substantially all the research activities must constitute a process of experimentation.Below are some examples of software-related research activities that would qualify:
- Developing new or improved products, processes, or formulas;
- Development of specifications and requirements;
- Concept development and ideation;
- Alpha and beta prototype development and testing;
- Design of software architectures;
- Database design;
- Regression and unit testing;
- Developing test cases for functionality and performance analysis;
- Streamlining internal processes;
- Activities to better manage customer relationships (data collection, storage, and analysis).
- Testing new solutions in the cloud;
- Activities to better manage customer relationships (collection, storage, and analysis);
- Coding of new software architecture or algorithms;
- Developing or applying for patents;
- Functional enhancements/features for existing applications for competitive advantages; and
- Programming software source code, compiling and testing source code.
The costs eligible for the research credit as QREs must meet the definition of IRC §174, which permits taxpayers to elect either to deduct research or experimental expenditures or to amortize the costs over a period of not less than 60 months. Those expenses are limited to:
- In-house wages and supplies attributable to qualified research;
- Certain time-sharing costs for computer use in qualified research; and
- 65% of contract research expenses, that is, amounts paid to outside contractors in the U.S. for conducting qualified research on the taxpayer’s behalf.
Record Keeping Requirements
To support qualified research, documentation must be maintained. In addition to issuing logs and meeting minutes, taxpayers may use email communications, technical reports, and patent applications to warrant the R&D credit. Identifying where there is indication of efforts to improve an existing process, research and development documentation is broad and takes many forms. Between information provided by taxpayers (or lack thereof) and the standards set by the IRS, policing of the R&D credit can be challenging for the IRS. This difficulty has shown up time and again in numerous court cases over the years. Keeping detailed records of research and development activities and consulting with a CPA firm that understands the credit can prevent future headaches and maximize your credit opportunity.
Examples of research and development documentation:
- Email communications which show failures, problems, or concerns encountered during the development process;
- Product or project specifications, descriptions, or proposals;
- Technical reports/test reports and results;
- Documentation of alternative supplies/materials/technology evaluated;
- Project diagrams/drawings/pictures including older versions and conceptual drawings which differ from the final product;
- Issue logs/meeting minutes/flowcharts or time schedules/schedules of releases;
- Patent applications or abstracts; and
- Contractual agreements with consultants and customers.
In addition to the beneficial federal credit, several states offer state-level R&D credits which provide additional benefits. These states include Massachusetts. Massachusetts’ “Research Credit” closely parallels the Federal rules and regulations with the stipulation that research is conducted within Massachusetts. Any software company that takes full advantage of Federal and state-level R&D credits has the potential to relieve a significant portion of their tax burden. However, understanding QREs and proper record keeping is a must.
Please let us know if you would like us to assist your software company with claiming the R&D credit. We would be happy to review any questions you may have and do an in-depth analysis of your software company to determine its eligibility for R&D credits. Contact us directly or through www.newburg.com .