Software companies have changed the landscape of how businesses in different industries operate by creating products that increase efficiency and productivity. To promote more innovation in the software industry, the US congress has expanded the access to R&D tax credits software, which can create significant tax-saving opportunities for a wide range of software companies.
Most of the expenses incurred by software companies during their research and development period are eligible. These include wages for product managers and software developers, contractor development expenses, and cloud computing services charges. Startup companies can also benefit when they apply credits to payroll tax liabilities.
A brief overview below provides us with an insight on how software companies may qualify for R&D tax credits.
R&D Credits Overview
For software companies that qualify, the federal benefit can go beyond 10% of the qualified expenses. In some states, additional credit benefits against state tax liability is even provided. In the state of California, for example, software development and technological companies are provided a credit of up to 7.5% of the qualified expenses. Although the California credit must be added to the income tax liability, in some cases, the federal credit can be applied against federal payroll tax. This, in turn, offsets the high cost of managing businesses in several high-cost states.
To help companies even more, credits are based on the location wherein the R&D is conducted, therefore more credits may be granted in multiple states when a company conducts R&D within each jurisdiction. For instance, a company with developers in Texas and California can claim credits in each state, even a federal credit.
R&D Tax Credits Software
Innovation in the software and technology sector is growing at an incredible pace. Companies keep developing and creating new or improved products to keep consumers engaged in a super competitive industry with fast-changing trends. In 2019 alone, tech companies spend more than $75 billion on R&D, which just shows how the potential for innovation in this sector is simply unmatched.
Advanced technologies such as Virtual Reality (VR), robotics, Artificial Intelligence (AI), Machine Learning (ML), and blockchain, have encouraged even more companies to put their resources into more Research and Development activities. Because of the large amounts of R&D in the software and technology sector, companies in this field are the most qualified to take advantage of the benefits they can get from the R&D tax credits.
Examples of R&D activities in the software and development sector:
- The development of new platforms
- Analyzing data
- Developing innovative algorithms
- Development or improvement of internal software
- Developing custom APIs
- Cloud computer integrations and development
- Developing augmented or virtual reality apps
- Optimizing and improving performance
- Implementations that support data science, artificial intelligence, machine learning, and computer vision systems
Understanding R&D Tax Credit
The R&D tax credits software is a tax incentive that encourages U.S. companies to increase spending on research and development in the USA. In general, a tax credit significantly reduces the amount of tax owed or can even increase a tax refund. If a company or business’ activities qualify for the R&D tax credit, then there are two ways to calculate it: the traditional method and the alternative simplified method.
Let’s take a look at both of these methods
Traditional Method
With the this method, the credit is 20% of the company’s current year qualified research expenditures over a base amount.
It can be a bit complicated to calculate the base amount, since it is the product of fixed-base percentage and the company’s average annual gross receipts for the past four tax years. You can read more about how to calculate the base amount of the fixed-base percentage online.
For companies that have not claimed the R&D tax credit software before, or for those that do not have the right data to determine the historical qualified research expenses are sure to find it easier to use the second method.
Alternative Simplified Credit Method
The Alternative Simplified Credit (AS) method for calculating the R&D tax credit has a four-step process involved:
- Determine the company’s average qualified research expenses (QREs) in the last three years
- Next, you multiply the average by 50%
- Subtract the results in step 2 from the company’s current year QREs
- Finally, you calculate the credit by multiplying the result in step 3 by 14%.
Who can Claim the R&D Tax Credit?
The R&D tax credit software is granted to any business that incurs expenses in an attempt to develop or improve products or processes in the USA.
There’s a way to determine if a company qualifies for the federal tax credit and it is through the four-part test:
- Eliminate Uncertainty –you have conducted the research to eliminate uncertainty concerning the development or improvement of a particular product or procedure. In other words, changes that are meant solely for aesthetic purposes do not qualify.
- Process of experimentation –your activities must involve some experimentation to fix or resolve technical uncertainty, such as systematic trial and error, modeling, simulation, or other methods.
- Technological in Nature –the research must be based on the hard sciences, such as physics, chemistry, engineering, biology or computer science.
- Qualified Purpose –the activity’s purpose must be to create a new or improve product or process that results to improved function, reliability, performance or quality.
However, there are certain activities which the tax code excludes from the R&D tax credit. The following activities, according to the IRS, are excluded:
- Research that involves adapting an existing product or process to the needs of a specific customer
- Research done after the start of commercial production
- Copying an existing product or process
- Surveys or studies
- Research related to some internal-use computer software
- Research done outside the U.S., Puerto Rico, or a U.S. territory
- Research funded by a private individual or governmental organization
- Research in the arts, humanities, or social sciences
Conclusion
Although it is not complicated to calculate the R&D tax credit, understanding which expenses qualify and whether you have the right documents to back them up, presents more challenge for many small businesses. Changes to tax laws, which usually take effect over an extended period of time, can also affect when and how you can claim your credits.
