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Tax
Less than one-third of companies eligible for the credit even know it exists, so two-thirds are losing out. If your clients’ activities and expenses qualify and they’ve maintained assiduous documentation, they can realize substantial tax savings…
Apr. 22, 2022
By Heidi Henderson
If your clients are in the field of software development, you might be pleased to learn that federal research and development (R&D) tax credits (designed to stimulate technological innovation in the United States) can reimburse them for developing new products, processes, or inventions; the credits can return a significant percentage back to them for qualified research activities and qualified research expenses. And over 40 states in the U.S. offer a state-level tax credit as well. To qualify for the credit, your client’s software doesn’t have to be new to the world—only new to the client’s company.
But before the client files a claim for R&D tax credits for software development with the IRS, what should you know about the credits? First, the IRS places all software into one of two categories: 1) external use, or third-party, software and 2) internal-use software. Each is judged according to different criteria.
External Software Criteria
An excellent example of external software is Microsoft. External software is intended for sale, lease, or license to customers. The IRS will accept the credit if the research passes this four-part test:
The IRS applies the four-part test to each business component—that is, each individual software version or module developed. Here are some examples of external-use software applications that may qualify:
Internal Software Criteria
Internal use software is devised to support a business internally. It can be used for administrative, financial, or HR management purposes or to accomplish support services within a business. Companies develop internal-use software, based on their own platform, so they can be more capable operationally or so that they can avoid paying a fee to a third-party vendor.
However, internal software must meet more stringent requirements. It must be highly innovative, and there can’t be anything like it in the marketplace. (External use software doesn’t have that requirement, because it’s based on an original platform.)
Internal use software must meet not only the four-part research test above, but also a heightened three-part test:
To determine the presence of significant economic risk, the internal software must pass an additional two-part test:
Qualifying Activities
Here are some examples of R&D activities that the IRS deems as qualifying for the credit:
Qualified Research Expenditures
Qualified Research Expenditures (QRE) are expenses judged by the IRS as acceptable for the credit. They include:
Expenses could include cloud computing costs and costs associated with offsite servers.
It’s important to note that the R&D tax credit is primarily a wage-driven credit. The lion’s share of R&D expenses is derived from the cost of paying eligible employees and consultants. However, for the purposes of applying for the R&D tax credit, all employees and consultants must be based in U.S., not India or another outsourcing location.
A few other points:
Above all else, documentation is key. Your client must have substantiation to defend the credit and support it when filing for the credit. The client should:
Potentially qualifying R&D job titles could include:
Your Client Can Bank Tax Savings to Fund New Projects
Less than one-third of companies eligible for the credit even know it exists, so two-thirds are losing out. If your client’s activities and expenses qualify and the client has maintained assiduous documentation, substantial tax savings can be realized—which can then be put back into the client’s business, so that the client can undertake even more research and win additional R&D tax credits! It’s a virtuous circle.
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Heidi Henderson is an executive vice president with Engineered Tax Services and a national tax consultant specializing in federal tax incentives. An active real estate investor, she holds both bachelor’s and master’s degrees from the University of Phoenix. If you have questions, you can email her at: hhenderson@engineeredtaxservices.com
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