R&D Tax Credit for Software Development

Has your company paid to create or improve software? You may be eligible for the research and development tax credit for software companies. The government offers incentives for R&D software development, both domestically and internationally.

What Is R&D Software Development?

Companies do R&D projects to acquire knowledge as a long-term strategy to improve or add new products and features. Examples include:

  • Discovering new security measures to protect against cyber threats
  • Developing new features for existing software to improve user experience
  • Building algorithms that help software run efficiently

What Are the 4 Pillars of R&D for Software You Develop?

Your company’s qualified activities must count as research and development to claim the credit. The IRS has an R&D tax credit four-part test to determine if you have qualified research activities and R&D expenditures.

The components of the R&D tax credit 4 part test are:

  1. Permitted Purpose

Your company’s research activity must tie directly to a new or improved business component but doesn’t have to be successful to qualify. Your purpose must be to increase the business component’s quality, function, reliability, or performance.

The components can be any of the following:

  • Product 
  • Technique
  • Process
  • Invention
  • Software
  • Formula

Small and incremental projects may qualify.

  1. Technological in Nature

Your R&E (Research & Experimentation) expenses or expenditures for software development must rely on hard-science principles, including chemistry, engineering, biology, physics, or computer science. The information you discover needs to be innovative or new to you.

  1. Eliminating Uncertainty

You must intend to eliminate technical uncertainty, whether in your methodology, capability, or business component’s appropriate design.

  1. Process of Experimentation

Your company must demonstrate experimentation by discussing, designing, or developing alternatives. Your process can include simulation, modeling, and systematic trial and error.

What Are the 3 Types of R&D?

Three overarching types of research and development exist.

  1. Basic Research

Basic research is studying the fundamental principles of a subject without intending to apply it specifically or have a commercial outcome.

  1. Applied Research

Applied research is the inverse of basic research. It aims to gain knowledge about a specific subject in a particular situation. Its goal is to solve a problem.

  1. Experimental Development

This type of research is a combination of basic and applied research. You begin experimental development once you gain understanding and knowledge from the other research types. Its goal is to develop new products or processes or improve existing ones.

What Products Fit the Definition of R&D Software Development?

The IRS broadly defines R&D for tax credit purposes, so many products fit the description. Examples include:

  • Artificial intelligence
  • Data processing
  • Cloud services
  • Augmented reality

What Are R&D Critical Success Factors?

It’s vital to know how to achieve R&D software development success. Ten factors generally contribute to a project’s success:

  1. Clear project mission
  2. Support from top management
  3. Detailed schedule and plans
  4. Active communication with the client
  5. Selection of the right people for the job
  6. Available technical tools
  7. “Selling” the project to the end users
  8. Timely monitoring and feedback
  9. Building a network and getting data to active parties
  10. Effective troubleshooting

What's the Difference Between R&D and Software Development?

Are R&D and software development just two sides of the same coin? They are different.

R&D experiments with different possibilities that might not result in a product. Software development creates a product. The goal of R&D is discovering unknown results and answers, while for software development, it is creating a defined, working product.

What Is Tax Section 174?

Historically, IRC Section 174 allowed taxpayers to choose to either:

  1. Deduct research and experimental expenditures as current expenses
  2. Capitalize and amortize them gradually

Federal Government’s Tax Cuts and Jobs Act changed the law. Currently, 174 capitalization rules state taxpayers and small businesses must capitalize and amortize research and experimental expenditures, including R&D software development costs. Read our Section 174 Analysis here for the latest updates surrounding the legislation.

What Are Section 174 Expenses?

Section 174 costs may include:

  • Wages you pay to employees conducting R&D
  • Materials you use
  • Third-party expenses

When Can You Capitalize R&D Costs for Software Development?

Accounting guidelines ASC 350-40 and ASC 985 govern when you can capitalize R&D costs for software development. According to the guidelines, you can capitalize on them when the technology reaches technological feasibility.

Analysis of the Build In In America Act

The Build It In America Act, consisting of three bills, was introduced by the House of Representatives on June 9. It aims to address concerns of businesses regarding rising interest rates and limited deductions for research and experimental expenses. The bills may significantly impact federal income tax payments for businesses, particularly concerning the R&D tax credit.

“This legislation represents a jobs package that will put money back into the pockets of hardworking Americans, who have seen so much of their paychecks stolen by inflation,” committee Chairman Jason Smith, R-Mo., said at the hearing. “This legislation makes it easier for entrepreneurs to pursue their American dream, and find the investment they need to start a new business. It helps small businesses grow and buy the new equipment needed to expand their facilities and be more productive.”

Potential Impacts on the R&D Tax Credit

R&D Tax Credit Extension:

Research and experimental expenditures need to be capitalized over a specific period. However, under the proposed act, taxpayers could deduct these expenses in the tax years beginning after December 31, 2021, and before January 1, 2026. This extension is vital to maintain the United States’ position as a global innovation leader.

Interest Expense Deduction Limitation:

While the act doesn’t eliminate the interest expense deduction limitation, it offers some relief to businesses. It broadens the base of the calculation by allowing the addition of depreciation and amortization before applying the 30% limitation. This change aims to help businesses affected by removing depreciation and amortization in the calculation.

Bonus Depreciation:

Under the proposed act, the 100% bonus depreciation provision would be extended for qualified property placed in service before January 1, 2026. This provision allows businesses to accelerate depreciation deductions and enhance their cash flow.

Learn More About Using the R&D Software Development Tax Credit

The R&D software development tax credit may provide your company cash savings every tax year you perform activities developing or improving processes and products. You can invest the money back into your business. KBKG can help you stay in compliance and take advantage of these benefits. Contact us today to learn how this tax credit can benefit your business.