How to Claim R&D Tax Credits for Software Development in 2024
R&D tax credits allow businesses to reduce their tax liability for expenses associated with their research and development activities.
In the article, we’ll be going through:
- How software companies can get the most out of this R&D tax claim grant
- What is and isn’t eligible for the tax credit
- The potential amount that can be earned for software development companies
What is the R&D Tax Credit?
The research and development tax credit encourages businesses to innovate and think ahead. It credits an average of 6.5-10% of QREs (Qualified Research Expenditures) including wages, supply costs, and contracted research expenses.
The R&D tax credit applies mainly to small and medium-sized businesses. It provides tax incentives for:
- Developing new products or services
- Improvements in old products or services
- The creation or testing of new prototypes
How Does the Research & Development Tax Credit Work?
The R&D tax credit provides tax breaks to companies that conduct research and develop new products, improvements, and other innovations.
If the firm has been in business for less than 5 years and has less than 5 million in gross receipts, the R&D tax credit can be applied to payroll taxes. This allows firms that have yet to profit to benefit.
Can Software Development Companies Claim The R&D Tax Credit?
Absolutely. The research and development tax credit is a tax incentive designed to encourage innovation across various industries, including software development.
R&D tax credits for software development can be a major benefit to companies of all sizes. Some tax credits even come as a refund to prior tax liabilities, providing something like a tax grant.
There are even additional incentives for small to medium-sized companies that make claims worth it for almost everyone. leading to substantial tax savings. Some could come as a refund to prior tax liabilities, effectively acting like a grant.
How to Claim R&D Tax Credits for Software
To claim R&D tax credits for software development in 2024, a company must meet the IRS's eligibility criteria.
The IRS established a four-part test to simplify the process of determining whether an activity can be claimed under the R&D tax credit. That’s why understanding the test is crucial for software companies seeking to leverage the incentive.
1. Check Your Eligibility
Qualifying projects meet the criteria of the four-part test and aim to develop or improve the business’s methods, processes, or software.
They do not have to be new to the world, but only new to the company. The IRS are looking for any activities that push past routine expectations and are innovatively solving problems in your industry, including ones such as:
- Improvements on industry standard approaches
- New software architecture or designs
- Upgrades in user interface design
2. The Four-Part Test
To qualify for the R&D Tax Credit, your projects must be engaged in activities that pass the four-part test that was created by the precedent set by the 2023 IRS case:
- Permitted Purpose – The project aims to create or improve the functionality, performance, reliability, or quality of a business component.
- Elimination of Uncertainty – The project begins with uncertainty about how to achieve the project goal and involves work to eliminate this uncertainty.
- Process of Experimentation – The project involves a systematic process of experimentation by evaluating one or more alternatives.
- Technological in Nature – The experimentation relies on the hard sciences, such as engineering or computer science.
Although still somewhat subjective, using previous examples to show that one’s efforts fall within the four parts is the most straightforward way to claim your case.
3. Speak to a Tax Planning Team
Engaging a tax attorney, especially one specializing in R&D tax incentives, can greatly help to maximize your potential claim. They can also help ensure that your claim is well-prepared for an IRS audit, giving you peace of mind.
A proficient R&D tax advisor can guide you through the R&D tax credit process by offering the following services:
- Establishing an early documentation process
- Collecting the necessary documentation
- Calculating the credit accurately
- Preparing for potential IRS examinations
Examples of R&D for Software
Eligible R&D activities for software companies include:
- Developing new algorithms
- New database management techniques
- Advancing cybersecurity measures
- Enhancing software architecture
- Improving user interfaces
- Developing user requirements for the software's functionality
- Project management including planning and oversight
- Developing functional, design or test specifications
- Finetuning and benchmarking
These examples underscore the wide range of innovative activities that can qualify for the R&D tax credit, highlighting the importance of considering all one’s projects for the R&D credit.
How The IRS Calculates the R&D Credit
The IRS uses two primary methods for calculating the R&D tax credit: the traditional and the Alternative Simplified Credit (ASC) method.
- Traditional method – Document and calculate 20% of research expenses over a base amount. The base amount is a fixed-base percentage multiplied by the average annual gross receipts for the last 4 years.
- Alternative Simplified Credit (ASC) method – This method calculates the credit based on 14% of the qualified research expenses (QREs) that exceed 50% of the average QREs for the 3 preceding tax years. If the company had no research expenses in any of the previous three years, the credit is 6% of the QREs for the current year.
The approach you should choose depends on the calculation method that best suits a company’s financial situation and R&D spending patterns.
How Much Can Software Development Companies Earn from the R&D Tax Credit?
The R&D tax credit is designed to support businesses that engage in research and development, offering them a pathway to reclaim a significant portion of their R&D expenditures.
The R&D Tax Credit for software can significantly decrease federal tax obligations.
Depending on their annual R&D spending, software companies can expect to offset their tax liability by up to 14% over 50% of the average of the last 3 years’ qualified research expenses (QREs).
You can also use the traditional method, which qualifies 20% of your research expenses over a specified baseline amount.
In addition, the credit offers qualifying small businesses the chance to offset up to $500,000 against the employer’s portion of social security liability.
Starting from tax year 2023 filings, this benefit has become particularly advantageous for startups and small enterprises focusing on innovation.
Companies that have yet to profit can carry forward unused credits for up to 20 years. This provision ensures long-term fiscal benefits, making the credit a strategic asset for future tax planning and benefiting companies even in their initial stages of development.
Finally, there are also some state-wide benefits to pursue. Although these vary by location, many states parallel the federal credit, further increasing the available benefits.
Check your state's documentation to find out if you can benefit.
Frequently Asked Questions
How Far Back Can You Claim R&D Tax Credits?
You can claim R&D Tax Credits for the last 3 tax years. If your company has missed out, you still have a chance to amend past returns and get the credit. This could lead to significant savings on already completed research and development initiatives.
How Should Software Development Companies Document R&D Expenses?
For software development companies, it’s essential to document all R&D activities. This includes:
- Project Descriptions: Documents that clearly outline what each project aims to achieve and how it fits within the Qualified Research Activity criteria.
- Experimentation Processes: Documentation of the experimentation or testing methods used to eliminate uncertainty in the development process.
- Working Hours Spent on R&D: Accurate records of employees' time spent on the project’s R&D activities, including project managers and support staff.
- Related Expenses: Expense trackers covering everything related to R&D, including materials, software, and subcontractor costs. Each of these can be included in the credit calculation.
If your company does happen to get an IRS audit, adequate documentation is the best defense to maintaining your R&D tax credits for software development.
They can also maximize the potential credit amount.
What Doesn’t Qualify for the Credit as a Software Company?
Not all activities performed by software companies qualify for the R&D tax credit. Generally, activities that are routine or administrative don’t count. This includes:
- Routine Software Maintenance: Tasks aimed at merely keeping software operational.
- Minor Software Updates: Minor updates or changes that do not significantly improve the software, such as tweaks and bug fixes.
- Software configuration: Adjusting and tailoring software to the needs of a client.
- Reverse engineering: Taking existing software and attempting to figure out how it works to make your own applications.
- Developing a business component too similar to another company’s.
The key to qualifying activities is that they must resolve some kind of technological uncertainties, not just make minor changes or copy already-built code.
Is Amortized Software Eligible for the R&D Tax Credit?
Amortized software can be eligible for the R&D tax credit if it meets the eligibility criteria.
This means software development must involve some kind of scientific or technological improvement using experimentation. It cannot improve the product only in financial terms, such as a better marketing campaign or payment structure.
That is, the improvement must be related to the software itself rather than how it is licensed or amortized over its lifetime.
Is Enterprise Software Eligible for the Credit?
Enterprise software development projects can qualify for the R&D tax credit. Here is a list of examples of eligible enterprise software:
- Developing new architectures
- New data management techniques
- Integrating software with new hardware
You need to show that the enterprise software solution contains an element of novelty and provides some form of technological advancement.
Is Custom Software Eligible for R&D Credit?
Custom software development is often eligible for the R&D tax credit, provided it meets the IRS’s four-part test for qualifying activities.
In practice, the custom software needs to involve a significantly improved product or process to count. Due to their client-specific nature, custom software usually does meet the criteria and can be claimed, but there are exceptions.
Start Your R&D Claim - Do You Qualify?
At RevenueSafe, we explore a business’s R&D methods and expenses to ensure a compliant claim of maximum value. Our process is simple, straightforward, and easy to use. So don’t wait, take the opportunity now to save money for your business.
