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February 14, 2018

R&D Tax Credit Incentives For Software Companies

The Research and Development “R&D” Tax Credit can be a significant and immediate source of cash for software companies, whether your company is developing cloud-based software, off-the-shelf software, or software that is embedded into products.  Recently, new IRS regulations were issued that have made qualifying and receiving benefits for the R&D Tax Credit even more appealing to many more companies, including start-up companies who may not be paying income taxes.  New regulations and IRS audit directives are taxpayer friendly and reflect a profound change in the position of the IRS and state taxing authorities:

R&D Tax Credit Incentives For Software Companies

  • The R&D Tax Credit is now a permanent part of the tax law
  • Starting in 2016 and forward, start-up software companies (revenues less than $5M, with gross receipts for no more than 5 years) may elect to utilize their R&D Tax Credits against payroll taxes up to $250,000 per year
  • Starting in 2016 and forward, R&D Tax Credits may offset the Alternative Minimum Tax for Eligible Small Businesses (average revenues of $50M or less for the prior three years)


Qualifying R&D Activities for Software Companies

r&d tax credits for software companies

Are you taking advantage of R&D Tax Credit Incentives for Software Development Firms?

Software development methodologies fit within the R&D Tax Credit regulations given the technical nature of the software technologies being developed, as well as the iterative process that most software development methods undertake.  Examples of these methodologies can range from traditional methods such as Waterfall Model, to agile software development such as Dynamic Systems Development Model and Scrum.

Many software companies overlook qualifying R&D expenditures that exist in many areas of their business. This is just one of the tax initiatives for software companies that you could be taking advantage of. If your company is involved in any of the following activities, you may be able to retroactively claim the R&D Tax Credit for federal and state purposes, obtain significant cash refunds and establish the methodology to claim the credit in the future:

  • Developing new or improved software and technologies
  • Developing functional specifications
  • Designing and developing software architecture
  • Developing the logical and physical design of the system
  • Programming and testing software source code
  • Documenting the internal design of the software
  • Developing software that is embedded in products
  • Creating new or improved software development tools
  • Developing interfaces/middle-ware to allow various technologies to communicate


R&D Tax Credit Qualifying Tests

In order for any software development activity to qualify for the R&D Tax Credit, the activity must meet the following criteria:

  • The software being developed must be new to the company or the company is making functional improvements to an existing software.
  • At the beginning of the software development, the company is uncertain:
    1. If it can develop the software
    2. How to develop the software
    3. What is the appropriate design of the software
  • The company must go through an iterative process of experimentation to evaluate the alternatives to achieve its goal of developing a new or improved software (i.e. design, program, test, document, redesign, reprogram, retest, etc.)
  • The software development must involve physical, biological, engineering, or computer science. The research cannot be in the “soft” sciences such as economics, psychology, management, marketing, or social science


Not all software development will qualify for the credit.  First of all, the software development must take place in the U.S.  Any software development that is conducted in foreign countries will not qualify for the U.S. R&D Tax Credit.  Additionally, post release bug fixes typically will not qualify as those fixes typically do not involve the development of new or improved functionality and/or may lack the technical uncertainty requirement. The R&D Tax Credit for software companies should be taken advantage of to help with business costs.


Benefit of the R&D Tax Credit for Software Companies

Calculating the R&D Tax Credit can be complex as there are many factors to consider when determining the computation method that will result in the highest tax benefit to the company.  As a rule of thumb, for purposes of evaluating the net federal tax benefit, the credit is equal to approximately 6.5% of every dollar of qualifying R&D expenditures.  This is a dollar for dollar reduction of the company’s tax liability.  This reduction of the tax liability is in addition to the tax deduction that was received for these R&D expenditures.  In addition to the tax benefit of the federal R&D Tax Credit as noted above, many states have tax credits that follow the federal tax credit regulations.

There are three categories of expenses incurred by a company that can qualify for the R&D Tax Credit:

  1. Wages of employees performing, supervising, or supporting qualified R&D activities. The amount of the employee’s wage will depend on the daily job functions of the employee
  2. Cost of supplies/materials used in the R&D process
  3. Cost of third-party contractors used to perform qualified R&D activities


How To Claim R&D Tax Credit?

The R&D Tax Credit has been a significant and immediate source of cash for the software industry for many years.  This credit has spurred innovation here in the U.S.  As the software industry continues to develop new technologies at a record pace, the R&D Tax Credit will continue to be valuable to U.S. companies who want to be competitive in the global market.

If your company has developed or continues to develop software applications, there is a strong chance that you can qualify for the R&D Tax Credit regardless of your industry.


This article is a guest post from Greg Elias, a Partner with Think, LLP (www.thinkllp.com) located in Southern California, focusing on federal and state tax credits and tax incentives.   Greg has 30 years of experience in accounting, tax and business consulting primarily with Deloitte and KPMG. As a member of Deloitte’s national tax consulting group, he was responsible for serving and advising Fortune 500 clients throughout the country focused on income tax planning and merger & acquisition consulting. During his tenure at KPMG, Greg was responsible for assisting both public and private clients with a variety of value-added accounting, tax and business consulting strategies. Prior to Think, LLP, Greg was a Regional Managing Director in charge of the Great Lakes region for a national firm specialized in performing R&D Tax Credit Studies. 

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