Does Software Development Count as a Research and Development Tax Credit?

Research and development (R&D) is so vital to U.S. economic growth that the government offers a specific tax credit to encourage it. Any company that develops software, should take advantage of it if eligible.

Why is the R&D Tax Credit a Big Deal?

The PATH Act of 2015 made the credit available to more companies, greatly enhanced it, and made it permanent. The R&D tax credit can provide an immediate source of cash for many small to midsize companies.

The R&D tax credit is a federal incentive that provides cash benefits for companies of all sizes. This applies to any business that uses science or technology to innovate or improve its products or processes. They must be conducting Qualified Research Activities (QRAs) within the United States to be eligible. 

Technology and software development often involve R&D, so these activities qualify for the R&D tax credit. Developing, improving, or modifying existing products is all part of it. However, not all software development qualifies—companies should carefully assess their activities against IRS criteria.

How Can Software Development Qualify for the Credit?

Software development can qualify for the tax credit when it's new to a technology company, even if it's not new to the world. This means that software just needs to be innovative within the company's operations.

Software developed to be sold, leased, or licensed to customers is classified as 'external use software.' This type of software qualifies as a QRA (Qualified Research Activity) for the R&D tax credit when it meets all four criteria of the R&D tax credit four-part test:

1. Technological in Nature: The activity must rely on hard sciences, such as engineering, physics, or computer science.
2. New or Improved Business Component: The research must aim to develop a new or improved product or process with functional enhancements. Purely aesthetic or cosmetic software changes would not qualify—the improvements must be functional. 
3. The Process of Experimentation: This involves evaluation of alternatives through modeling, simulation, testing, or other methodical approaches.
4. Technical Uncertainty Test: This test requires elimination of technical uncertainty. The company demonstrates that questions existed about achieving the desired outcome and documents the resolution process.

Apply the four-part test to each business component (i.e. each software version or module developed). Examples of external-use software applications that may qualify include:

• Document Management Systems
• Educational Software
• Marketing Software
• Firmware
• Cloud-based Applications
• Mobile Applications
• AI and Machine Learning Systems

Software developed for internal use may also qualify for the credit, but it faces a higher standard. Internal use software can be used for financial reporting, HR functions, or customer support. .

Internal use software must not only satisfy the standard four-part research test but also meet an additional three-part heightened test. This test requires demonstrating that the software:

1. Is innovative, meaning it results in a substantial and measurable improvement.
2. Requires significant economic risk, meaning its development requires the commitment of substantial resources and involves uncertainty regarding its success.
3. Is not available commercially, meaning it cannot be purchased or licensed without significant modifications.

Determining significant economic risk involves an additional two-part test. Software development involves significant economic risk if a combination of factors exists, including the commitment of significant resources and substantial uncertainty about recouping the R&D investment within a reasonable time. 

How is the Credit Calculated?

Technology companies also benefit from credit calculations. This is because it includes the salaries of developers who work on QRAs. This means a significant portion of development costs can contribute to the credit. To calculate the credit, you need to run a few numbers; qualified research expenditures (QREs) for the tax year must be totaled for each QRA.

Qualified Research Expenditures

QREs are the expenses eligible for the tax credit calculation. This includes:

• The wages of the employees who carry out the R&D.
• The supplies used during the R&D process.
• A portion of what a contractor spends on R&D activity.

A regular credit is equal to 20% of the excess of QREs over a base amount.

The base amount is derived by multiplying a fixed-based percentage by the average annual gross receipts for the four years before the credit year, but it can not exceed 50% of the QREs.

What it looks like: 

Base Amount <= .5QRE * Fixed-Based Percentage * Average of Annual Gross Receipts Over the Last 4 Years

The fixed-based percentage is derived from QREs divided by gross receipts during the years 1984-1988, not to exceed 16%. 

For companies formed after 1988, start-up companies use a flat 3% for the fixed-based percentage for the first five tax years. The amount of the credit computed is income unless the reduced credit is elected.

This can be calculated more easily. 

Alternative Simplified Credit

Many companies elect the alternative simplified credit (ASC) over the regular credit for its simplicity. The ASC method for calculating the research credit follows a four-step process:

1. Figure the company’s average QREs for the past three years.
2. Multiply that average by 50%.
3. Subtract the result of Step 2 from the company’s current year QREs.
4. Calculate the credit by multiplying the result by 14%.

If there are no QREs in any of the three preceding tax years, the ASC is 6% of the QREs for the current tax year. See below for an example of the ASC.

Alternative Simplified Credit (ASC) Example:

The R&D credit is an incremental credit rewarding companies that continue to increase their spending on QRAs. The ASC example above shows how the credit amount increases each year resulting from QREs steadily increasing from Year 1 to Year 5. The credit is intended to motivate companies to increase their investment in QREs from prior years.

How is Credit Applied?

The credit is a dollar-for-dollar credit used to offset federal income taxes owed. If no income tax is owed for the applicable tax year, the credit can be carried forward up to 20 years. C corporations claim the credit on their business tax return. S corporation shareholders and partners claim the credit on their individual tax returns.

While the credit has historically been limited by the Alternative Minimum Tax (AMT), the PATH Act significantly softened this limitation. Now, eligible small businesses can use the credit to offset AMT owed. An eligible small business holds less than $50 million in average gross receipts for the three preceding years. This will make the credit more available to small to mid-size pass-through business owners.

The Inflation Reduction Act of 2022 further enhanced the R&D tax credit by increasing the maximum amount that qualifying small businesses can apply against payroll taxes from $250,000 to $500,000.

Qualified small businesses can elect to use up to $500,000 of their research credit to offset the employer's portion of social security tax (FICA). A qualified small business holds less than $5 million in annual gross receipts and has gross receipts for no more than five years. 

This is a great enhancement for start-up companies. Start-ups can now receive an immediate benefit from the credit to offset payroll tax. This is better than having to postpone this income tax offsetting credit until profitability is achieved.

Additional Benefits to Consider

The ASC can now be claimed for all open tax years. This means eligible companies can look back to prior year returns, typically the last three tax years plus the current year, to see if they qualify for potential credits that weren't claimed when they first filed.

Many states offer their own version of the R&D tax credit, with qualifying criteria and benefit amounts that may differ from the federal credit. It can reduce current and future state income taxes owed in addition to federal income taxes owed.

The PATH Act also made the R&D tax credit permanent, and this permanence has been maintained through recent tax legislation. The credit has been available as a temporary credit since 1981 and now is here to stay. 

Next Steps?

Corporations and partnerships can use Form 6765, ‘Credit for Increasing Research Activities,’ to calculate and claim the credit. It is critical to follow IRS and applicable state guidelines as well as maintain proper documentation of the qualified research activities..

Navigating the R&D tax credit can be complex, with many details to consider. A tax professional can help ensure compliance and maximize potential benefits. Do not miss out on potential tax savings–reach out to an expert and start the conversation.