R&D Tax Credit for Software Startups

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.

What is the R&D Credit?

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.

Who Can Use the R&D Tax Credit?

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.

How can a Software Startup Benefit from the R&D Tax Credit?

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.

How to Determine What Activities Qualify for the R&D Tax Credit?

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:

• Low Risk Activities that will almost always qualify for the R&D credit;
• Moderate Risk Activities that often fail to qualify for the R&D credit;
• High Risk Activities that almost always fail to qualify for the R&D credit.

All activities completed must “constitute elements of a process of experimentation related to a new or improved function, performance, or reliability or quality.”

What Activities Qualify for the R&D Tax Credit?

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:

• Early testing of products (e.g., alpha and beta testing);
• Development of software utility programs, such as debuggers, backup systems, performance analyzers, data recovery, etc.;
• Designing new constructs, algorithms, architectures, or database management techniques;
• Developing specialized technologies for image processing, artificial intelligence, or speech recognition among other things; and
• Software developed as part of a hardware product where the software interacts directly with the hardware to make them function as a unit.

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.

What Activities Do Not Qualify for the R&D Tax Credit?

Often, the activities that don’t qualify for R&D tax credits are moderate- and high- risk activities such as:

• Research on a product after commercial production has already begun;
• Maintenance on existing software products;
• Enhancing existing software products;
• Configuring third-party software applications to the taxpayer’s specific needs;
• Debugging software and detecting flaws;
• Installing new hardware or new versions of software;
• Updating or writing hardware device drivers to support new hardware;
• Research related to the adaptation of an existing business component to a particular customer's requirement or need;
• Research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business components;
• Any (1) efficiency survey; (2) activity relating to management function or technique; (3) market research, testing, or development (including advertising or promotions); (4) routine data collection; or (5) routine or ordinary testing or inspection for quality control;
• Research conducted outside the U.S., Puerto Rico, or any territory of the U.S.;
• Research conducted in social sciences, arts or humanities; and
• Any research to the extent it is funded by a grant, contract, another person or governmental entity.

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.

Next Steps

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.