There’s no shortage of innovation in the software industry, making it a natural fit for R&D tax credits. However, improperly calculating and claiming these credits can have consequences in the form of IRS penalties and fines.
But first, what is the R&D tax credit?
The R&D tax credit is a dollar-for-dollar tax savings that directly reduces a company’s tax liability. There’s no limitation on the amount of expenses and credit that can be claimed each year. If the R&D credit can’t be used immediately or completely, any unused credit can be carried forward for up to 20 years.
In addition, previously filed tax returns can typically be amended for up to three years to claim the R&D credit retrospectively, providing an avenue to recoup previously paid taxes.
New or small business may be eligible to apply the R&D tax credit against their payroll tax for up to five years starting in 2016. The R&D credit is available both at the federal and state level, with approximately 40 states offering an R&D credit to offset state tax liability.
Here are some of the most common client questions we encounter on this topic.
How much can a company save with R&D tax credits?
There’s no limit, but there are several factors that can impact savings. Some clients save a few thousand dollars and others save millions of dollars. Generally, the more a company spends to innovate, the more they can potentially save—sometimes 10%-15% of their qualified expenses. However, the main indicator is the number of software engineers they employ.
What does the credit apply to?
Because software development tends to be experimental in nature, many activities could potentially qualify for the credit. Designing new features, products, systems, and platforms, or making improvements to existing platforms could all qualify. Even making improvements to performance could qualify. The development life cycle—writing the code, creating a new application, testing and getting feedback, recoding, or redeveloping it until it actually works—lends itself well to R&D credits.
What activities qualify?
Most clients develop software, both for internal and external use. Software designed for internal use generally requires a much higher level of innovation. Machine learning, artificial intelligence, and algorithm updates could also qualify.
Some of the activities that could qualify include developing the following:
- Code for new software architecture or algorithms
- Functional enhancements and new capabilities for existing applications, designed to create a competitive advantage
- Intranet and internet software in which scale and complexity present technological challenges
- Flexible, high-quality, and scalable rule engines to manage and automate complex business structures and models
- Software to better manage customer relationships through improved collection, storage, and analysis techniques
- Specialized technologies, such as artificial intelligence or voice recognition applications
- Interactive software to support the delivery of multimedia entertainment, such as streaming music or video or Internet video games
- Software applications to use internally or to interact with customers or vendors
To apply for these credits, what’s the next step?
The same entrepreneurial spirit that drives the software industry can often motivate companies to try and calculate these credits on their own, but it’s important to remember that there’s a certain level of documentation required to successfully claim the credit—and there are penalties if done incorrectly.
First, assess if your activities qualify and how many credits are available. A qualified professional will go through an assessment process, gathering financial information and conducting interviews of the software engineers and other employees. This allows them to put deliverable packages and tax return numbers together.
We’re Here to Help
Each company’s goals, values, and resources are unique, which makes it important to develop a customized project plan to identify, calculate, and support your company’s R&D credits and activities.
With recent increased IRS scrutiny around R&D credits, it’s crucial to understand what’s necessary to substantiate a credit claim. To learn more about R&D tax credits, see Five Misconceptions about R&D Tax Credits—and if You Qualify, or request a complimentary credit benefit estimate to see how much your company could save.