If you’re considering investing in software unique to your organization (i.e., custom software), or have already made the move, now is a great time to investigate the Research and Development (R&D) Tax Credit to learn if you can save cash to fuel growth.
What is the R&D Tax Credit?
The Research & Development Tax Credit – IRS Section 41 is a federal benefit that incentivizes innovation and growth for companies that invest in qualified research and development activities by reducing federal taxable income. This means your business can receive a dollar-for-dollar tax credit while also being able to deduct expenses related to R&D.
Can you use R&D Tax Credits for custom software?
Definitely. We’ve worked with our clients and their tax advisors to navigate R&D tax credits for custom software. Qualified research and development activities are related to the development, design, or improvement of products, processes, formulas, or software.
The custom software being developed doesn’t have to be new to the world; just new to your business to qualify. Developing, improving, or modifying existing software is also considered fair game.
The use case for the custom software that qualifies for the R&D Tax Credit includes commercial use (also referred to as external use software) or internal use. However, internal-use software (IUS) has a few additional requirements to qualify. IUS must be software that supports the business internally, such as:
- Financial management
- Human Resources management
- General day-to-day support services of your company
Types of custom software that likely would not qualify as IUS would be:
- Software developed to enable customers to purchase products online
- Bank transaction software
Do your custom software activities qualify for R&D Tax Credits?
Whether your custom software activities are for external or internal use, they must meet the IRS’s four-part test.
If it is for internal use, it must also meet the 3-Part High Threshold of Innovation Test. To qualify for the credit, IUS must meet three additional criteria outlined in the 3-Part High Threshold of Innovation Test. “High threshold of innovation” is defined as a reduction of costs or an increase in speed that produces substantial or economically significant results.
How do you claim the R&D Tax Credit?
It would be best if you discussed this with a tax professional; however, Corporations and Partnerships will need to file IRS Form 6765, Credit for Increasing Research Activities to claim the R&D tax credit. As part of the process, you’ll need to identify qualifying expenses and provide adequate documentation that shows how these costs meet the requirements under Internal Revenue Code Section 41.
Documentation requirements for the tax credit are broadly defined. Per the IRS tax code, taxpayers are required to “retain records in a sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.” Financial records, business records, oral testimony, and technical documents may be used for this purpose. Examples of these could be the following:
- Employee Form W2s
- Payroll registers
- Time tracking data
- Orders/invoices/receipts for qualified supplies or from your software development partner
- Technical design requirements
- Specs or schematics
- Prototype documents
- Test plans and results
Does your business have to build the custom software internally to qualify?
It doesn’t matter who performs the work (i.e. if it’s built using an internal team or an external software development partner). Qualified contract research expenses require qualifying businesses to bear the economic risk of the work performed by the software development partner, regardless of whether it’s successful or not.
As research expenses require qualifying businesses to bear the economic risk of the work performed by the contractor, ensure you understand the intellectual property (IP) ownership language in your contract with your software development partner, as it can vary.
Can you qualify for the tax credit with custom software built previously?
If you’ve already invested in custom software but didn’t know about the credit, don’t worry – you can still take advantage of it. Businesses can claim the R&D credit retroactively by filing amended returns for any open tax years, which is three years in most cases. However, the time frame may be longer if the organization endured losses during that period.
You may wait to claim the credit, as performing the R&D tax study is expensive, costing tens of thousands or more. Depending on your investment in year 1, it may make sense to wait to perform the tax study.
What if you don’t meet the R&D credit requirements?
Ask your CPA about Section 174 expenses. While all R&D credit expenses must qualify as a Sec. 174 expense, not all Sec. 174 deductible expenses need to meet R&D credit requirements. Businesses often have Sec. 174 expenses even if they don’t claim R&D tax credits.
Understanding the R&D Tax Credit can mean more money for your business. Some have found millions of dollars in the form of R&D Tax Credits due to activities related to custom software development. While getting started can seem like the most challenging part, certified public accountants (CPAs) who thoroughly understand the qualifications for the R&D Tax credit can help you maximize your business’s return on investment while maintaining compliance.
Author’s Note: Frogslayer Digital Ventures, LLC does not provide tax-related advice or services. The information in this blog is not intended to be used as professional tax advice. If you are interested in utilizing the R&D tax credit, discuss it with your business’s CPA.