In today’s competitive software development landscape, companies continually invest in research and development (R&D) to innovate and maintain a competitive edge. However, many overlook the valuable financial opportunity of R&D tax credits. These credits reward investments in technological advancement, offering substantial financial relief that reduces costs and fosters growth. This guide outlines how software development firms can strategically leverage R&D tax credits to maximize their benefits.
Navigating R&D Tax Credits
For software development companies, R&D tax credits encompass a broad range of activities aimed at creating new or enhancing existing software products, processes or technologies. To qualify, these activities must be technological in nature, driven by innovation, involve solving technical uncertainties and employ a systematic approach to experimentation. Key items to be aware of include:
- Identifying Eligible Activities: To maximize R&D tax credits, companies must thoroughly identify all qualifying activities. These typically include, but are not limited to, developing new software solutions, improving existing systems, prototyping new functionalities, designing custom integrations and resolving technical challenges encountered during development.
- Documenting R&D Activities: Rigorous documentation is crucial to substantiate R&D tax credit claims. Companies should maintain meticulous records that include comprehensive project descriptions, detailed time logs of employee involvement, financial statements outlining R&D expenditures and technical documentation illustrating the innovative aspects of the projects. Utilizing dedicated project management tools or specialized R&D tax credit software can streamline the documentation process and ensure accuracy.
- Staying Updated with Regulations: Tax laws and regulations concerning R&D tax credits are subject to change. Software development companies must stay informed about legislative updates that may impact their eligibility or affect the calculation of credits. Regular consultations with tax advisors ensure ongoing compliance and enable companies to adapt their R&D strategies to maximize the benefits derived from these credits.
R&D tax credits provide a significant financial incentive for software development companies dedicated to innovation. By understanding eligibility criteria, meticulously documenting qualifying activities, using appropriate tools, collaborating with professionals and staying updated on regulations, companies can optimize their R&D tax credit claims. This helps reduce tax liabilities and provides additional resources for ongoing innovation and growth, strengthening their competitive edge in the software industry.
The Start-up Company Rules and Monetizing the Credit
Many young software companies perform qualified activities and would like to take advantage of the R&D tax credit, but due to the infancy of their company, they may be in a net operating loss (“NOL”) position. This means that they have no current tax liability, and although they can carry forward the credit as a deferred tax asset for twenty years, they do not reap the immediate benefit of the credit. However, for a company that qualifies as a start-up, there is another option to monetize the credit.
Companies that are less than five years old and have less than $5 million dollars of gross receipts in each of those five years may be eligible for the payroll tax credit offset. This is an election that must be made on a timely filed return, and the election allows the taxpayer to offset their payroll tax liability up to $500,000. This presents an excellent option for companies that are unable to utilize their tax credits due to being in an NOL position.
The Impact of Section 174
Remember that Section 174, amended by the Tax Cuts and Jobs Act of 2017, currently requires the amortization of R&E expenditures over 5 years (domestic expenses) or 15 years (foreign expenses) period. This differs from the prior rules, which allowed immediate deductions in the current year. Although this is simply a timing difference, the overall effect is an increase in tax liability in the earlier years of the amortization and a resulting reduction in cash flow.
The rule change has been quite unfavorable, and there is currently legislation supported by both parties in Congress to make a change to revert to the old rules, but there is no timing or guarantee that a change will happen. As a result, software companies must carefully evaluate their Section 174 expenses and should look into claiming the R&D credit to mitigate the impact of the amortization on their tax liability.
Contact Our Experts
For personalized guidance and to maximize your R&D tax credits, contact our experts today:
- Tommy Zavieh, National C&I Practice Leader | tommy.zavieh@frazierdeeter.com
- Sheila Anderson, C&I Partner | sheila.anderson@frazierdeeter.com
- Allen Tobin, C&I Principal | allen.tobin@frazierdeeter.com