8 minute read
Starting a new business in the software industry can be a costly endeavor. They can have a large amount of upfront expenses and an unanticipated future payout. Software startups may be surprised at how much they can save by utilizing research and development (R&D) tax credits at federal and state levels.
Generally, the R&D tax credit is offered by the government to incentivize businesses to bear the costs of research and development required to develop new and novel products. R&D tax credits are available at the federal tax level and through many states. By providing a cushion in the form of a credit, businesses are incentivized to spend funds on R&D that may have been budgeted elsewhere.
The R&D tax credit is available to a broad range of industries and businesses, including finance, manufacturing, agriculture, food & beverage—and, most importantly, software development companies! Recent changes in the tax rules allow small- and medium-sized businesses more accessibility to the R&D tax credit. Now, almost any business can take advantage of the R&D tax credit so long as the expenses and activities are “qualified” under the applicable statutes and regulations as defined by the IRS.
With expanded availability of the R&D tax credit, it is advantageous to be aware of what activities may qualify for the credit. The IRS recently released guidelines that can help advise taxpayers determine what counts as a qualified software development activity for the purpose of the R&D credit. Notably, these guidelines are not binding and cannot be relied upon in court. Taxpayers will want to use these guidelines as a baseline for what constitutes a qualifying activity, but should seek advice from their tax counsel or advisor to confirm their validity.
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To qualify for the R&D tax credit, the company must have incurred qualified research expenses such as: (1) W-2 wages paid or incurred for services performed by an employee; (2) amounts paid for supplies used to conduct qualified research; or (3) amounts paid people other than employees for the performance of qualified research services. The IRS divides activities by software companies into three categories:
All activities completed must “constitute elements of a process of experimentation related to a new or improved function, performance, or reliability or quality.”
The following activities listed below are just a few examples of “Low Risk Activities” that will most likely qualify for the R&D tax credit:
The U.S. Department of Treasury has noted that “[w]hether expenditures qualify as research or experimental expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents.” In other words, the determination is very factual, and the success or failure of the product being researched does not affect eligibility for the R&D tax credit. Each business should assess the activities completed and consult with their tax advisors and legal counsel to determine the best way to utilize available tax benefits.
Notably, the R&D tax credit can be used towards a company’s payroll tax—rather than its income tax—but only if: (1) the company has less than $5 million in revenue; (2) it’s been less than five years since first revenue; and (3) employees (and payroll taxes) are based in the U.S.
Often, the activities that don’t qualify for R&D tax credits are moderate- and high- risk activities such as:
The likelihood of these types of activities qualifying for the R&D tax credit ranges from high to moderate risk. However, each companies’ situation is different—software startups may want to seek tax advice to determine which processes qualify for the R&D tax credit.
The R&D tax credit can offer huge benefits to software startup companies, providing the company with the incentive to continue to develop new and novel products while saving the company large sums of money. Make sure you are utilizing the R&D tax credit to the fullest extent possible.
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