Research and Development Tax Credits for Software Development

An often-over-looked tax credit for companies that conduct software development is the Research & Development Tax Credit (R&D) for Federal and state tax credits. There is the traditional R & D tax credit and the Alternative Simplified Calculation. The credit applies to United States expenditures only.

Four tests are required to be met in order to qualify for the credit:

1 – There needs to be a qualified business purpose. The development of new or improved software; new algorithm or operating system, new database management system or firmware; mobile app design and development; backend support systems for websites; creating integration and connections between existing or purchased software or just new modules or integration with artificial intelligence.

2 - It needs to be Technical in Nature. The use of software engineering, blockchain, virtual reality, artificial intelligence, machine learning and edge computing.

3 – There is Technical Uncertainty. The activities are undertaken to discover information and eliminate technical uncertainty with the system’s architecture, technology, methodology and design.

4 - There is a Process of Experimentation. The process attempts to discover information, eliminate technical uncertainty and evaluation of alternatives; alpha/beta testing, verification, integration, functional, performance, regression and stress testing.

Please note that for internal use software projects, there are 3 additional elements:

- It must be innovative and should result in a reduction of cost or economically significant improvement;
- It must involve significant economic risk where substantial resources are committed in the development because of technical risk and
-The software is not commercially available for purchase, lease or license without significant modification.

What Expenses qualify?

Most of the expense is in the salaries and wages of software engineers, programmers, software testers, quality assurance personnel and an allocable portion of the oversight by upper management.

Outsourcing of domestic contract research expenses at 65% of cost; supply costs that are used and consumed in the process and rental of computer time are also qualifying expenditures.

What’s the tax benefit?

Federal 6.5% to 10% tax credits plus additional state tax credits. Tax credits can be carried forward for up to 20 years.

The Cares Act now allows net operating losses to open closed tax returns so a further look into missed tax credits should be considered.

The PATH Act of 2015 permitted the R & D credit to be claimed against AMT or payroll taxes with less than $5 million in gross receipts.

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