Guide for Software Companies When Claiming R&D Tax Credits

Maybe you’ve heard that somehow a variety of practices associated with the implementation of updated or upgraded software might be considered for the R&D Tax Credits. Needless to say, the benefit is aimed at promoting the advancement of novel and advanced processes and technologies. The credit will help to reduce the uncertainties associated with creativity and recognize foresight.

R&D tax credits

When analyzing the seven major stages of the Software Development Lifecycle (SDLC), it’s the fourth stage which development and coding entail operations that qualify for special tax credits.

Thus, while the new rules favored commercial software providers, you do not preclude your business solely just because you do not sell software to external parties. Treasury Decision 9786 from 2016 defines the testing operations count as Internal Use Software (IUS).

Software Projects That are Eligible for R&D Tax Credits

Below are software projects that your company can do that may make you eligible to claim R&D tax credits:

  • Your company is creating cutting-edge technology for future projects or enhancements to current R&D efforts;
  • Your company is formulating techniques for extending the capabilities of application software programs or system software;
  • Your company is creating modifications to database software, scripting languages, or operating systems;
  • Your company is creating application development tools, such as data portability tools, image recognition tools, or character recognition tools;
  • Your organization is engaged in developing new data processing approaches, like those of novel object representation and data structures;
  • Your enterprise is working on new with novel techniques for recording, transmitting, manipulating, and preserving records;
  • Your company is creating new software that can run new computer hardware;
  • Your company is creating software that has the ability to run devices that have pre-installed operating systems;
  • Your company is formulating integration means for hardware and software platforms.

Software Projects That are Not Eligible for R&D Tax Credits

Another equally important thing to learn is the activities that will not make you eligible to claim for R&D Tax Credits, and these are the following:

  • Software developments that are being conducted outside of the United States;
  • When your company is only doing configuration of software applications;
  • When the activity being done are only routinary maintenance and production;
  • When the activity being done are routinary QC testing and post-release bug fixes on the software;
  • When the activity being done on the change of user interface is merely for purely cosmetic design.

Doing taxes

Activities That Can be Included in Claiming R&D Tax Credits

Below are the activities that do not disqualify you when claiming for R&D Tax Credits:

  • When the activity involved is defining technical goals;
  • When the activity involved is for you to identify uncertainties;
  • When you are doing studies on feasibility;
  • When the activity involves assessing new and competing technologies;
  • When the activity involves analysis, design, and development of a certain technology;
  • When the activity is aimed towards the production of a technical specification or other types of documents that will serve as support and explanation to the R&D project and advancement;
  • When the activity involves project planning and management.

R&D Expenses That Can Be Claimed For Software Projects

You will receive benefits on expenditures that have been recorded in the Profit & Loss account, along with capitalized expenditures under some cases as long as the assets purchased have been classified as Intangible Assets.

Here are the majority of costs that you can claim for software projects:

  • The cost for staff salaries at gross amount;
  • Payments made to agency workers or workers that have been hired externally;
  • Payments made to freelancers or subcontractors;
  • Payments that have been made to licensing the software;
  • Payments for consumable items like heat, light and power, materials, and equipment that have been directly used or have been transformed by reason of the R&D process.

Documentation is a Must When Claiming R&D Tax Credits

Since the large proportion which is about 95% of the eligible research and development costs for applications are attributable to employee pay and expenses paid to US-based contractors, it is essential to retain clear and accurate data. To assert R&D Tax Credits correctly, you must know precisely the amount of time that is being expended on qualified activities.

One common practice is to keep track of each initiative, all personnel concerned, and each hour expended on every eligible operation. Therefore, in your documentation, you must be able to prove the following:

  • The project that is being done is eligible for the R&D tax credit. Although there is a risk that it may not be allowed, just keep in mind that a “time and materials project” is not going to make you eligible for R&D tax credits.
  • The activity that you are doing is not disqualified when claiming R&D tax credits, thus, the activity must be able to pass every part of the Four-Part Test.
  • The amount that is being claimed for the R&D tax credit is valid, therefore the amount you are applying for must be precise.

Tax filing checklist

Potential Challenges for Software Companies When Claiming R&D Tax Credits

Below are some of the hurdles that a software company may encounter when deciding whether or not they are going to claim R&D Tax Credits:

Employees involved in the project are highly-compensated

It is essential to evaluate the credit effect of highly paid employees, with an emphasis on employees who are in executive positions. Since software firms often expand rapidly, compensation will escalate in lockstep with the organization’s growth.

Whenever these workers make a sizable contribution to the overall sum of eligible research expenses, the IRS can conduct a comprehensive examination of the executive’s activities and the reasonableness of the salaries assigned to the credit. Corroborating evidence of executives’ trained resources, such as professional reports, correspondence, and calendar appointments related to R&D, might be needed.

The proper identification of the project and documentary support

The IRS requires the company to use a project-based framework that specifies and takes into account the project on which credit is initially claimed.

Additionally, the IRS may refuse a credit claim if it judges that a company has not clearly demonstrated eligibility for the credit. It is essential that the credit estimate adheres to IRS standards, including quantifying costs where project-based accounting is used and meeting disclosure requirements.

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