Software Companies and Who Can Qualify for the Federal and WA R&D Tax Credit
Software and the R&D Tax Credit
By Andrew Lane, MBA, BSME,Â Partner at Tri-Merit, LLC – R&D Tax Specialists
Software developers are very strong candidates for the Research & Development tax credit. Many of the standard activities involved in software development potentially qualify for the tax credit, which can translate into substantial tax savings.
The information below is intended to assist in identifying potentially qualifying activities and further explain aspects that need to be considered when quantifying them for the research tax credit. First and foremost, the basic requirement to qualify for the credit is that a project must meet all four parts of the âfour-partâ test to be eligible:
- Permitted Purpose: The project must be intended to be useful in the development of a new or improved business component for the taxpayer. A business component may include a product, process, technique, formula, invention, or software.
- Technological in Nature: The project must be undertaken for the purpose of discovering information that is technical in nature. Thus, the activity must rely on the principles of physical sciences such as engineering, biology, or computer science.
- Elimination of Uncertainty: The project must be intended to eliminate uncertainty related to the development or improvement of a business component. Uncertainty can relate to the components capability, development method, or optimal design.
- Process of Experimentation: The project must evaluate one or more alternative solutions through the development, refinement, and testing of different options. This typically involves the use of simulation, modeling or a systematic trial-and-error methodology.
In looking at software developers, it is clear that many of the standard processes they are engaged in can be very R&D tax credit friendly. However, within the software development umbrella there are several different types of software development activities, each with their own nuances related to the credit:
- Proprietary Software Product Development
Companies, such as Microsoft or Oracle, which develop their own proprietary products that are held for sale or lease by the taxpayer are the most straight-forward candidates for qualified software development, as it relates to the research tax credit. The basic requirement is that the qualified research activities meet the â4-part testâ requirements.
- Custom Software Development
Custom software development (i.e. software that is developed under contract as a service for a third-party) can potentially qualify for the credit, assuming the 4-part test is again met for the research activities.
However, an important consideration for custom software development to qualify is whether the contract the work is performed under passes the exclusion for âfunded researchâ found in IRC Â§41(d)(4)(H). For the contract to be eligible, two conditions must both be met. First, the payments must be contingent on the development activities being successful. Second, the developer must retain rights to the intellectual property that is developed.
- Mobile Apps
A relatively new trend in the software development market is the emergence and rise of developers focusing on applications for mobile devices (such as phones, tablets, etc.). As a large percentage of these mobile app developers are early stage companies, the potentially limiting factor here is their profitability and ability to benefit from the credit by reducing taxes due.
- Web Developers (Website Development)
In general, standard web development (i.e. building a website) is not likely to qualify for the research tax credit. A significant portion of the work is generally related to the aesthetic design, which is specifically excluded from qualified activities, and HTML coding is not likely to rise to the level of technical uncertainty and experimentation required to qualify.
However, there are research activities performed by web developers that may qualify. Specifically, the back-end development of new software applications and platforms such as CRM applications and ecommerce engines utilizing source code developed in a programming language such as C++ or Java, which ties in to a web-based front end may qualify.
- Internal Use Software
Software that is developed for internal use (meaning software that is not intended to be sold as a product) is generally excluded from qualified research activities under IRC Â§41(d)(4)(E).
As with anything, there are exceptions for when internal use software development can still qualify for the research credit.Â If the software satisfies the following three additional tests, then it could still be eligible: (1) âThe Innovation Testâ â The software must be intended to be unique or novel and to differ in a significant and inventive way from prior software. (2) âThe Economic Risk Testâ â The taxpayer must commit substantial resources and there is substantial uncertainty whether the investment will be recovered within a reasonable time. (3) âThe Commercial Availability Testâ â No commercially available software could be used for the intended purpose without modifications that meet the first two requirements.
Clearly, many of the fundamental areas related to software development can provide meaningful opportunities to explore R&D tax credits. Whether the software development activities are intended to result in a new or improved product, internal-use software, or something else, it is clearly an area of tax savings that should be fully explored.
A significant portion of the activities performed by a companyâs employees such as the software programmers, software architects, software analysts, QA testers, and other supporting team members may qualify. Because the research credit is primarily a wage based credit, employee involvement could translate into meaningful tax savings.
Some general examples of software development activities that may qualify for the credit include:
- Development of specifications and requirements
- Concept development and ideation
- Alpha and beta prototype development and testing
- Design of software architectures
- Database design
- Regression and unit testing
- Developing test cases for functionality and performance analysis
Additional information can be found at http://www.tri-merit.net
Washington State High Technology B&O Tax Credit
By Sabin Pradhan, CPA, MST,Â Tax Manager at Hagen, Kurth, Perman & Company
The state of Washington also has a tax credit that is available for qualifying research and development expenses that can be used to offset the Washington State Business and Occupation tax (B&O tax). The credit is available to companies in five fields including advanced computing. The definition of the qualifying expenses for wages and supplies are similar to the federal credit. Therefore development wages including compensation of a proprietor or partner that qualify for the federal credit should qualify for the High Tech B&O Tax credit. The credit is equal to 1.5% of the qualifying expenses reduced by 0.92% (not 92%) of the B&O taxable income. Since the B&O tax rate for services itself is at 1.5%, a significant amount of the B&O tax can be offset by the High Tech B&O Tax Credit.
Andrew Lane, Partner, Tri-Merit
Andrew is a Partner based out of Tri-Meritâs Detroit, Michigan office. For the past seven years, he has been responsible for managing the execution of Tri-Meritâs R&D tax credit studies, including the calculations of qualified research expenses, credit amounts, and the compilation of supporting engineering documentation and reports. In addition, he has been involved in defending R&D tax credit audits at both the federal and state levels, and has presented on the R&D tax credit to multiple state and local organizations from an engineering viewpoint.
Andrew has spent over 13 years involved in various engineering and manufacturing roles, having worked with a broad range of companies, industries and markets. Prior to founding Tri-Merit, Andrew worked with a number of engineering firms as a technical consultant, focusing on improving new product development processes, and manufacturing process development and improvement, through technology. Andrew has also spent years working in various engineering positions, specifically in both the semiconductor and automotive industries.
Andrew holds a Masters of Business Administration in Finance degree from DePaul University and a Bachelor of Science in Mechanical Engineering degree from General Motors Institute.
Sabin Pradhan CPA, MST, Tax Manager, Hagen, Kurth, Perman & Company
Sabin is a tax manager at Hagen, Kurth, Perman & Company, a Seattle based CPA firm. Sabin specializes in helping privately held companies (including those in manufacturing and high technology) and their owners in tax planning and compliance. Sabin’s past work includes helping clients plan for crossborder tax issues, stock based compensation, multistate tax filing planning, and review of the availablity of tax incentives including tax credits for clients.