R&D Tax Credits for Software Development
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 credits. 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
- Financial management
- Human resources management
- Support services, including marketing, facility services, legal services, security services, etc.
Non-Internal Use Software
Software developed for non-internal use includes the following types:
- Software for sale, lease, license and third-party use
- Computer software and hardware developed as a single product
- Computer software for control of a production process
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:
- execute banking transactions
- track the progress of the delivery of purchased goods
- searches a business’ inventory for product availability
- saves and retrieves documents on a third party file server
- manages the purchase of tickets for transportation or entertainment
- orders services via the internet
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.
New or Improved Business Component
The software development activities must relate to the performance, quality, reliability, or functionality of the envisioned software.
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.
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.
Technological in Nature
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:
One: 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.
Two: 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.
Three: The Commercial Availability Test
The software is not commercially available.
Software Development Qualifying Expenses
- Wages paid to software engineers and computer programmers as well as those supporting or supervising the development activities
- Subcontracted software developers
- Leased computer costs associated with licenses for use in developing cloud-based software platforms
- Regardless of whether the software is developed for internal use or not, the development work must be performed in the United States to qualify for the research tax credit.
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:
- No gross receipts for any year prior to the four years preceding the current taxable year
- Less than $5 million in gross receipts in the year the research credit is claimed
- Have qualifying research activities and expenditures
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.