R&D Tax Credits for Software Developers

R&D Tax Credit | February 23, 2021 | 7 min read

Software developers are in the business of innovation. As such, they are ideal candidates for the research and development tax credit. The R&D tax credit was essentially authorized for the specific purpose of encouraging the research and development of new products and processes. That said, a majority of software developers or software development companies fail to take advantage of America’s largest tax incentive. In 2016 alone, nearly $16 billion in R&D tax credits were claimed, yet software developers continue to leave money on the table by not claiming the research and development tax credits made available to them. The primary reasons software developers aren’t claiming R&D tax credits are they either don’t know the credits exist or don’t believe they qualify to claim the R&D tax credits. Software developers may also be unaware of some recent changes in the R&D tax credit laws that have expanded the scope of the program so that more taxpayers are able to claim R&D tax credits than ever before. The best way to learn whether your software development activities are R&D tax credit eligible is to work with an experienced and well-qualified R&D tax credit consultant. Schedule a free consultation with Clarus R+D to learn more about the benefits of the R&D tax credit program or to discuss whether you are eligible to claim the credit. Clarus’ technology-driven solution empowers companies to fuel their growth with America’s largest tax incentive.

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Software developers can claim R&D tax credits

The R&D tax credit is the biggest tax incentive available to software developers. Since its introduction in 1981, the R&D tax credit has expanded so that more and more software developers and software development companies are able to claim the tax credits. In order for your software development company to be eligible to qualify for the R&D tax credit, it must engage in certain qualified research activities.

Clarus R+D has worked with software developers across the country to help them claim the R&D tax credit. Examples of software development activities and innovations eligible for the R&D tax incentive include:

  • Programming software source code
  • Designing and developing the structural software architecture
  • Application design and testing
  • Establishing electronic interfaces and functional relationships between various software modules
  • System software development 
  • Evaluating and establishing functional specifications
  • Conducting unit, integration, functional, performance and regression testing
  • Compiling and testing source code
  • Developing new or improved technologies
  • Alpha/Beta testing

I encourage any entrepreneur or company with significant dev expenses to pursue the R&D tax credit. The ROI compared to the amount of time spent is worth it.

Jeff Wilkins / FMX

You don’t have to be among the largest software developer companies to take advantage of the research and development tax credit. Small software developers and startups are even eligible to claim the R&D tax credit. In fact, recent changes to the applicable laws have made it easier than ever for more software developers to take advantage of the R&D tax credit.

Learn how your business can claim the R&D tax credit

Benefits of R&D tax credits for software developers

The research and development tax credit is a government-sponsored tax incentive available to companies who conduct research and development within the United States. The credit was implemented as a Congressional response to the decline in research spending which negatively impacted the Country’s economic growth, productivity gains, and overall global competitiveness. The R&D tax credit was initially implemented in 1981 and has since been reauthorized several times. In 2015, when the Protecting Americans from Tax Hikes (PATH) Act was adopted, the Research and Development (R&D) credit became a permanent part of the tax code

Many software developers assume the R&D tax credit is available only to the big software development companies. This, of course, is not the case. You don’t have to be as large as Microsoft or IBM to be eligible for the credit. A software developer is eligible for the incentive as long as they are engaged in qualified research activities, regardless of the size of their company. Under the current tax code, any company that develops or improves products or processes may be eligible for the credit. The number of software developers who engage in eligible activities is ever-increasing; software development is, by its very nature, innovative. Clarus R+D is your tax credit consultant of choice to help your software development company take advantage of the research and development tax incentive.

Many software developers are unaware of the tremendous benefits of R&D tax credits. For most software development companies, the credit is worth 7-10% of qualified research expenses. This is a dollar-for-dollar credit against taxes owed. Plus, it carries forward 20 years. For startups, applying the credit against payroll taxes is a valuable, non-dilutive funding opportunity. Eligible expenses for the R&D tax credit include U.S.-based wages, contracting, and supply costs. Most typically, wages are the largest qualified expense, but there must be nexus between the expense and qualified project. Additionally, most states offer an R&D tax credit that can supplement the federal R&D tax credit.

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Software development and R&D tax credit eligibility

Working with a professional R&D tax credit consultant, like Clarus R+D, is the best way for you to determine your tax credit eligibility. In order to be eligible for the research and development tax credit, your software development company must engage in qualified research. Qualified research generally is private sector or commercially driven development intended to yield innovation within a scientific or technological field. The following four-part test determines whether an activity is considered qualified research and, thus, eligible for the R&D tax credit.

Permitted Purpose

The purpose of the activity or project must be to create new (or improve existing) functionality, performance, reliability, or quality of a business component. A business component is defined as any product, process, technique, invention, formula, or computer software that the taxpayer intends to hold for sale, lease, license, or actual use in the taxpayer’s trade or business.

Elimination of Uncertainty

The taxpayer must intend to discover information that would eliminate uncertainty concerning the development or improvement of the business component. Uncertainty exists if the information available to the taxpayer does not establish the capability of development or improvement, method of development or improvement, or the appropriateness of the business component’s design.

Process of Experimentation

The taxpayer must undergo a systematic process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities. Treasury Regulations define this as broadly as conventional implementation of the scientific method to something as informal as systematic trial and error process.

Technological in Nature

The process of experimentation used to discover information must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science. A taxpayer may employ existing technologies and may rely on existing principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement. Research activities that qualify for R&D tax credits must be conducted in the U.S. If your business does any of the following, it likely qualifies for the R&D tax credit:

      • Develops or designs new products or processes
      • Enhances existing products or processes
      • Develops or improves upon existing prototypes and software

Exclusions

Even if your work passes the four-part test, there are a few exclusions to the R&D tax credit. Expenses incurred under the exclusions will not qualify for the incentive. Some of these already appear in the four-part test, including the need to rely on hard sciences. The activity must take place in the U.S. and cannot include routine data collection or market research. Also, activities cannot receive funding from an unrelated third party because your company might not retain ownership of the resulting intellectual property. 

Clarus R+D will work with you to help you understand what is considered qualified research for purposes of determining R&D tax credit eligibility.

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R&D tax credits: Understanding the software development life cycle

In order to be eligible to claim the R&D tax credit, software development activities must satisfy the four-part test described above. In general, software development follows a seven part life cycle described more fully below.  

1. Planning

In a software development project, planning comes first. Typically, the outputs from the planning stage include project plans, cost estimations, and the identification of procurement requirements

2. Feasibility or requirements analysis 

The second phase in a software development project is where businesses will work on the source of their problem or the need for a change. This is where a system analysis is conducted to determine a business’s needs, define how those needs can be met, and identify responsible parties.   These activities related to gathering requirements and analysis likely qualify as R&D:

  • Gathering Detailed Information
  • Defining Requirements
  • Prioritizing Requirements
  • Developing User-Interface (UI) Dialogs
  • Defining Functional Requirements

3. Systems Design and Prototyping

The third phase describes, in detail, the necessary specifications, features and operations that will satisfy the functional requirements of the proposed system which will be in place. This is the step for end users to discuss and determine their specific business information needs for the proposed system.

4. Software Development

The fourth phase is when the real work begins—in particular, when a programmer, network engineer and/or database developer are brought on to do the major work on the project. Software development turns your project’s requirements and prototypes into working code.

5. Software Testing

The fifth phase involves systems integration and system testing (of programs and procedures)—normally carried out by a Quality Assurance (QA) professional—to determine if the proposed design meets the initial set of business goals.

Testers check for:

  • Code quality
  • Code meets the stated requirements
  • Code performs per the specifications
  • Evidence of secure development principals

6. Implementation and Integration

The sixth phase of the software development life cycle involved the deployment of code on a server or its integration across multiple systems.  

7. Operations and Maintenance 

The seventh and final phase involves maintenance and regular required updates. This step is when end users can fine-tune the system, if they wish, to boost performance, add new capabilities or meet additional user requirements. In the operations and maintenance phase, developers watch software for bugs or defects.

Clarus R + D will work with you and your team to help determine if your software development activities  satisfy the four-part eligibility test and are, therefore eligible.   

Contact Clarus R+D for additional information

R&D tax credit consultants: What to expect

Working with a professional R&D tax credit advisor is the best way to determine eligibility and maximize your benefit. Here is what you can expect by selecting Clarus R+D as your R&D tax credit consultants:

      • Clarus R+D provides a team of professionals with expert credentials able to answer all your R&D tax credit questions.
      • Our proprietary software streamlines R&D studies which maximizes your ROI.
      • Clarus has expert knowledge of the IRS regulations relating to the research and development tax credit, IRC Section 41, as well as the regulations pertaining to state-specific research and development credits.
      • Clarus has extensive experience in recognizing qualified research activities and expenditures.
      • Our time-proven methodology has yielded maximum benefits to our clients.
      • The Clarus team has helped hundreds of clients claim millions in R&D tax credits.
      • We place emphasis on helping growth businesses take advantage of the tax incentive.
      • Clarus does the work for you; our web-based app allows you to enter information at your own pace.
      • We have extensive IRS and state audit experience and provide our clients with audit support.
      • We have maintained an exceptional success rate in applying for the R&D tax credit.
      • We work directly with our clients and their respective accounting firm and payroll processor.
      • Our process saves valuable time and resources within the engineering and finance departments.
      • Our fees are very competitive.
      • Our performance, success rate, and unparalleled quality of service result in high client loyalty.

Learn more about R&D tax credits

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Schedule a free consultation with our team of experts to learn more. We’ll discuss the R&D tax credit and help you determine if our solution is a fit for your company.

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Clarus R+D gave us tremendous ROI. Easy software. Helpful people. Reasonable fees.

Richard Cumberland / Zupt

 

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ABOUT CLARUS R+DWith custom software backed by a team of tax experts, Clarus R+D specializes in tax credits for growth businesses. Our technology-driven solution simplifies the process, maximizes benefit, and ensures compliance. We partner with accounting firms, financial advisors, investors, payroll providers, and more.

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