How Does the R&D Tax Credit Apply to Software Companies?

Mention research and development, and people tend to think of lab coats and scientific equipment, but the Research & Development (R&D) Tax Credit is available to a wide variety of businesses, including software companies.

Let’s take a closer look.

R&D Tax Credit: An Overview

The Research and Development Tax Credit was designed to incentivize U.S.-based businesses to increase their spending on research and development.

It’s available to any business that spends money in an attempt to develop new or improved products or processes on U.S. soil. The IRS has a simple, four-part test to help companies decide whether their activities qualify for the credit:

  1. The Section 174 Test: The business must have carried on the research to eliminate uncertainty about the development or improvement of a product — aesthetic changes alone don’t qualify.
  2. The Discovering Technological Information Test: The process of experimentation must rely on the hard sciences, including computer science and engineering.
  3. The Business Component Test: The purpose of the research or development must be to create a new or improved product or process that will be held for sale, lease, license, or used in the company’s trade or business.
  4. The Process of Experimentation Test: The activities must include experimentation — through modeling, simulation, systematic trial and error, or other methods — to resolve technical uncertainty.

If your software company’s activities qualify, you may use a variety of qualified research expenses to calculate the credit, such as:

  • Wages paid to employees directly working on, supervising, or supporting research and development
  • Supplies used for the development process, such as materials used to fabricate prototypes
  • Contract research expenses paid to a third party performing qualified research activities
  • The cost of cloud service providers or leased computers and servers used the research and development process

The research doesn’t have to be successful for the expenses to count, but accounting for those expenses is critical. The majority of qualifying R&D expenses for software companies stem from employee wages and contractor fees, so it’s crucial to maintain documentation on exactly how much time those employees and contractors spent working on qualifying activities.

Calculating the R&D Credit

If a company’s activities qualify for the credit, there are two ways to calculate it:

  • Under the traditional method, the credit is worth 20% of the company’s current year qualified research expenses over a base amount. That base amount is the product of a fixed-base percentage and the company’s average annual gross receipts for the prior four years.
  • Under the Alternative Simplified Credit (ASC) method, the credit is worth 14% of the company’s current year qualified research expenses over 50% of its average qualified research expenses for the three prior tax years. If the organization didn’t have research expenses in any of the prior three years, the credit is worth 6% of qualified research expenses in the current year.

Companies that haven’t claimed the R&D credit in the past or don’t have data on their historical qualified research expenses usually have an easier time using the ASC method.

Many states have their own R&D tax credit programs, making this an extremely valuable tax credit for companies that qualify.

Applying the Federal R&D Credit to Payroll Taxes

The federal R&D credit can, in some circumstances, offset the company’s federal payroll tax.

This is especially helpful for startups with a lot of research costs and little to no tax liability. New and small businesses can apply up to $250,000 of their R&D tax credit to their payroll tax liability for up to five years, allowing them to receive a tax break for their research activities even if the company isn’t profitable in its early years.

To qualify for the payroll tax credit, the company must have:

  • Five or fewer years of gross receipts
  • Less than $5 million in gross receipts in the year the company is claiming the credit

Organizations have to make this election on an originally filed return, meaning if they missed out on applying the R&D credit to payroll taxes in a prior year, they cannot correct the oversight by filing an amended return.

Here to Help You

If your software company conducts research activities that may be eligible for either the federal or a state R&D tax credit, claiming it can generate significant tax savings over several years. Whether you’re interested in an R&D credit feasibility study or any of our other Tax Services, our team is here to help. Get in touch!

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