This is the first in a series of articles about how research and development (R&D) tax credits are a tax-intelligent strategy that can be applied to a wide variety of industries. In this article, we’ll delve into how the software and gaming industries are prime candidates for taking advantage of R&D tax credits.
The IRS offers R&D tax credits to incentivize technological progress by reimbursing companies that develop new products, inventions, and processes; a percentage of those costs are returned to the company for what are termed Qualified Research Activities and Qualified Research Expenses. You don’t have to be a large company to qualify for the credit. For many years now, Engineered Tax Services has helped companies of all sizes across the United States to identify these expenditures and receive the tax benefits they’ve been missing.
Companies in the software and gaming industries can potentially claim R&D tax credit for:
- Third-party sale, lease, or license software (for both new releases and version upgrades)
- Internal-use software (for both new releases and version upgrades)
The IRS treats third-party versus internal-use software a bit differently when evaluating their ability to qualify; the agency requires a higher level of innovation for internal use software, with proof there’s nothing similar already on the market. However, software that will be for sale or license needs to only show that technical coding and development was performed.
What Activities Qualify?
During the seven main phases of the Software Development Lifecycle (SDLC), it’s the fourth — development and coding — where R&D tax credits are the most applicable. This is when the major project deliverables are built, and programmers, network engineers, database developers, and others create code to meet requirements and specifications within the required technical environment. Next comes quality assurance and user acceptance criteria, and finally unit testing is conducted to ensure all user and business needs are met.
Potentially qualifying activities include:
- Iterations of source coding
- Iterations of algorithm development
- Alpha testing
- Beta testing – if it’s necessary to go back to incorporate feedback and develop additional source coding for functionality, performance, or quality
- Technical, environmental, system, and program documentation
- Supervisors’ and managers’ time involved in leading, directing, and coaching the staff performing qualifying activities
However, the development of user/help documentation during this phase doesn’t qualify.
Keep Clear and Accurate Time-Accounting Documentation
It’s important to keep clear and accurate time-accounting documentation, because 95% of qualifying R&D expenses for software relate to employee wages and U.S.-based contractor fees. To properly claim R&D tax credits, you need to know exactly how much time is spent working on qualifying activities. List each project, all staff involved, and every hour spent on each qualifying activity.
Your documentation must prove:
- The project qualifies for the credit. There must be a risk involved that you undertook for the IP rights; for instance, a “time and materials project” does not qualify.
- The activities qualify. Do your activities pass each part of the Four-Part Test? (See below.)
- The amount qualifies. The monetary amount you are requesting must be accurate.
The Four-Part Test
Take this simple four-part test to determine if you qualify for research and development credits, according to criteria established by the IRS:
- Permitted Purpose: The activities must relate to new or improved business components, function, performance, reliability, and quality.
- Technological in Nature: The activity performed must fundamentally rely on principles of physical or biological science, engineering, and computer science.
- Elimination of Uncertainty: The activity must be intended to discover information to eliminate uncertainty concerning the capability, method, or design for developing or improving a product or process.
- Process of Experimentation: The taxpayer must engage in an evaluative process that can identify and evaluate more than one alternative to achieve a result. This may include modeling, simulation, or a systematic trial and error methodology.
Here is an example of how ETS helped one client with R&D tax credits:
|Total Qualified Wage Costs for Development||Net Federal Research Credit|
|December 31, 2018||$326,667||$25,807|
|December 31, 2017||$272,139||$18,311|
|December 31, 2016||$214,042||$15,060|
Because it can be a complex process to obtain R&D tax credits for software development activities, it can be wise to work with a knowledgeable partner like Engineered Tax Services that has many years of experience in this specialized area of tax law.