Four Things to Know About R&D Tax Credits for Software Companies

This article was updated August 29, 2023.

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—IRS penalties levied by federal and state tax authorities.

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 a company can claim each year.

If the company can’t use the R&D credit immediately or completely, they can generally carry that over to prior or future years.

In addition, companies can typically amend previously filed tax to claim the R&D credit retrospectively, providing an avenue to recoup previously paid taxes.

New companies may be eligible to apply the R&D tax credit against their payroll tax during their start-up years. The R&D credit is available both at the federal and state level, with nearly 40 states offering an R&D credit to offset tax liability.

Common questions on this topic follow.

How Much Can a Company Save with R&D Tax Credits?

There’s no limit, but several factors can impact savings. Some companies save a few thousand dollars while others save millions. 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 remains the number of software engineers they employ and the engineers’ location.

Where Does the R&D Tax Credit Apply?

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 performance improvements can qualify. The development life cycle—designing a new application, writing code, testing and obtaining feedback, recoding, or redeveloping it until it actually works—lends itself well to R&D credits.

Generally, the more a company spends to innovate, the more they can potentially save—sometimes 10%–15% of their qualified expenses.

What Activities Qualify for the R&D Tax Credit?

Companies that develop software do so both for internal and external use. Software they design for internal use generally requires a much higher level of innovation. Machine learning, artificial intelligence, and algorithm improvements could also qualify for R&D credits.

Other qualifying activities include developing:

  • 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

What’s the Next Step in Applying for R&D Tax Credits?

When seeking R&D credits, it’s important to remember that you’ll need a certain level of documentation to successfully claim the credit—and you could face penalties if you make errors.

First, collect preliminary information about your company’s potential qualified activities and expenses, which will help estimate the credit benefit.

Next, you’ll want to formulate a plan for calculating and documenting the credits, which may involve analyzing detailed financial data, interviewing technical personnel, and gathering additional records to support claiming the credit.

How Do the Capitalization Requirements for Section 174 Expenses Impact the R&D Credit?

The Tax Cuts and Jobs Act of 2017 (TCJA) made significant changes to the way businesses can deduct research and experimental (R&E) expenses.

Beginning in the 2022 tax year, businesses are required to capitalize and amortize R&E expenses over five years for domestic costs and 15 years for foreign costs. This change means that businesses must now capitalize R&E expenses, including any software development costs, as a requirement.

Capitalization of R&E expenses doesn’t affect the amount of expenses that can be claimed for the R&D tax credit. The R&D tax credit is still calculated based on qualified research expenses (QRE), which are a subset of R&E expenses that meet certain criteria.

Therefore, software companies may still be able to claim the R&D tax credit, even if they must capitalize and amortize a portion of their R&E expenses over a longer period.

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 increased scrutiny around R&D credits at the federal and state levels, it’s crucial to understand what’s necessary to substantiate a credit claim.

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