Companies who develop software for sale or use by customers or third parties, or for operating equipment or products, or for use in their business may be eligible for R&D Tax Credit. These research credits are a dollar-for-dollar reduction of federal and state tax liabilities.
The IRS’s R&D Tax Credit regulations relating to software development activities segregate software development into two general categories: Internal Use Software and Non-Internal Use Software.
Internal Use Software
The regulations define internal use software as software developed for G&A functions, namely:
Non-Internal Use Software
Software developed for non-internal use includes the following types:
Generally, non-internal use software includes home, education and business programs as well as games, entertainment and communication applications. Other examples of software that qualify for the R&D credit includes applications that:
The Four Tests
According to the IRS, activities relating to the development of both internal use and non-internal use computer software qualify for the federal research tax credit providing the development efforts satisfy the ‘Four Tests’ described in the regulations and where the taxpayer bears the financial risk.
1. New or Improved Business Component
The software development activities must relate to the performance, quality, reliability, or functionality of the envisioned software.
2. Elimination of Uncertainty
The development activities must involve the elimination of uncertainty such as whether the desired performance or result could be achieved, or whether the appropriate logic or algorithms to achieve the desired results could be realized, or whether the appropriate configuration of the software code could be determined.
3. Process of Experimentation
Substantially all of the development activity must represent a ‘process of experimentation’ involving more than one possible approach toward achieving the desired result, and where the capability or method of achieving that result is uncertain at the outset.
4. Process of Experimentation
The process of experimentation used to eliminate the technological uncertainty must rely on principles of the physical or biological sciences, engineering, or computer science.
Additional Three-Part Test for Internal Use Software
In addition to the Four Tests, software developed for internal use purposes must also meet the following three tests:
1. High Threshold of Innovation Test
The software is innovative as where the software, if successfully developed, would result in a reduction in cost or an improvement in speed that is substantial and economically significant.
2. The Significant Economic Risk Test
The software development involves significant economic risk as where the company commits substantial resources to the development and there is uncertainty that such resources would be recovered within a reasonable period.
3. The Commercial Availability Test
The software is not commercially available.
Software Development Qualifying Expenses
Payroll Tax Credit for Small Businesses
For emerging software development companies in the start-up phase, the R&D Tax Credit can be used to offset the corporate payroll tax up to $250,000 per year for five years. To qualify, the company must meet the following requirements:
To learn if your company qualifies, talk to the R&D Tax Credit team at Source Advisors. We can quickly determine if your firm qualifies and help you decide if an R&D study would be financially valuable for your firm. Our small team approach provides maximum benefit with minimal disruptions to your business.