june2022 - 29

FEATURE
R&D Tax Credits Can Help Your Clients
Subsidize Software Development
IF YOUR CLIENTS are in software development, federal research and development
tax credits designed to stimulate innovation in the U.S. can reimburse them for
developing new products or processes. The credits can return a significant percentage
back to them for qualified activities and research expenses. And 40 states in
the U.S. offer a state-level credit as well. To qualify, your client's software doesn't
have to be new to the world-only new to the client's company.
But before the client files a claim for R&D tax
credits for software development with, what should
you know about the credits? The IRS places all
software into one of two categories: 1) external
use, or third-party, software, and 2) internal-use
software. Each has different criteria.
EXTERNAL SOFTWARE CRITERIA
An example of external software is Microsoft. External
software is intended for sale, lease, or license to
customers. The IRS will accept the credit if the
research passes this four-part test:
* It must be technological in nature: The activity
must rely on hard sciences, such as engineering,
physics, or computer science.
* It must involve a new or improved business component:
Your client must demonstrate there was an intention
to develop a new or improved product or process,
not a simple aesthetic change.
* It must involve the process of experimentation: The
client must evaluate alternatives through modeling,
simulation, testing, or other methods.
* It must pass the technical uncertainty test: The
client must eliminate technical uncertainty via
research. The client must explain how he or she
strove to achieve the desired outcome and how he
or she reached that goal.
The IRS applies the four-part test to each business
component-that is, each individual software version
or module developed. Here are some examples of
external-use software applications that may qualify:
* Document management systems
* Educational software
* Marketing software
* Firmware
INTERNAL SOFTWARE CRITERIA
Internal use software supports a business internally.
It can be used for admin, financial, HR, or support
services. Companies develop internal-use software,
based on their own platform, so they can be more
capable operationally or so they can avoid paying
a third-party vendor.
However, internal software must meet more
stringent requirements. Internal use software must
meet not only the four-part research test above,
but also a heightened three-part test:
* The software must be highly innovative.
* Its development must introduce significant
economic risk.
* A similar product must not be available commercially.
To determine the presence of economic risk,
internal software must pass an additional test:
* The client must commit significant resources.
* Substantial uncertainty must be involved. Can the
R&D investment be recouped within a reasonable
amount of time?
QUALIFYING ACTIVITIES
Here are some examples of R&D activities that the
IRS deems as qualifying for the credit:
* Alpha/beta testing
* Application and platform design and testing
* Coding, programming, testing (such as for functional,
integration, or user interface purposes)
* Developmental cloud computing activities
* New architectures, new algorithms, or new database
management techniques
* Software and hardware product development to
further communication and interaction
* Specialized tech design (such as image processing,
artificial intelligence, or speech recognition)
* System software development (for example, operating
systems or compilers)
QUALIFIED RESEARCH EXPENDITURES
Qualified Research Expenditures are expenses the
IRS deems acceptable for the credit. They include:
* Wages of the employees who carry out the R&D
* The supplies used during the R&D process
By Heidi Henderson
* A portion of what a contractor expends on R&D activity.
Expenses can include cloud computing costs and
costs associated with offsite servers.
Note that the R&D tax credit is primarily a
wage-driven credit. Most R&D expenses are incurred
paying employees and consultants. For the R&D tax
credit, these employees and consultants must be
based in the U.S. A few other points:
* Funded research is disqualified.
* Claiming the Employee Retention Credit can reduce
the amount of the R&D credit the client might be
entitled to, because the ERC reduces wage costs.
* In addition, the client must own the intellectual
property rights to the platform being constructed.
Documentation is key. Your client must have
substantiation to defend the credit and support it
when filing for the credit. The client should:
* Track the list of projects or revisions. Each version
of the release would be a new project.
* Keep a list of projects and what the staff members
are working on.
* Have time tracking in place.
* Include employee titles.
Qualifying R&D job titles can include:
* Director of Software Engineering
* Programmer
* Senior technical leads
* Software analyst
* Software developers
* Software integration engineers
YOUR CLIENT CAN BANK TAX SAVINGS
TO FUND NEW PROJECTS
Less than one-third of companies eligible for the
credit even know it exists, so many are losing out. If
your client's activities and expenses qualify and the
client has maintained documentation, substantial
tax savings can be realized, which can then be put
back into the client's business, so the client can do
even more research and win additional R&D tax
credits! It's a virtuous circle. ■
Heidi Henderson is an executive vice president with
Engineered Tax Services and a national tax consultant
specializing in federal tax incentives. An active real
estate investor, she holds both bachelor's and master's
degrees from the University of Phoenix. If you have
questions, you can email her at: hhenderson@engineeredtaxservices.com
JUNE
2022 ■ www.CPAPracticeAdvisor.com
29
http://www.CPAPracticeAdvisor.com
june2022

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