Navigating a Software R&D Tax Credit Claim
Software development is a broad range of activities – from functional enhancements to app development. It becomes easy to confuse which aspects of software development are considered R&D in the eyes of the IRS, since all forms of it are referred to as development. But the IRS indeed has some pretty strict thoughts on what software activities are truly research and development.
As with any industry, the IRS follows the rules outlined in I.R.C. § 41. To summarize these rules, qualifying R&D refers to activities must:
- Fundamentally rely on the principles of hard sciences (eg. physical or biological sciences, engineering, or computer science)
- Involves the identification of technical uncertainties concerning the development or improvement of the business component
- Use a process of experimentation to evaluate alternative solutions to overcome these uncertainties
- This process may involve modeling, simulation, systematic process methodologies etc
There is a very helpful guideline to follow to see if your activities will qualify for the R&D tax credit. This guideline has been curated based on the precedence set out in other cases and audits, so following this will surely help guide you in the right direction, and may help you understand what the IRS is really looking for.
The IRS splits software activities into three risk categories:
- High risk means that these activities usually fail to constitute qualified research under I.R.C. § 41(d).
- Activities that don’t advance or create new system architectures and, instead, apply slight modifications or integrations with existing architectures and systems are often high risk.
- Quality control, bug detection, and minor updates do not have sufficient technical uncertainty, and often involve routine or standard modifications/updates.
- These maintenance activities involve work that is well known in the industry and does not contribute new knowledge or require a process of experimentation.
- Moderate risk means that these activities often fail to constitute qualified research under I.R.C. § 41(d).
- These activities are split down the middle and it often comes down to the details of the project. Many of these categories could effectively describe projects that have no uncertainty, or much technical uncertainty
- Low risk means that these activities rarely fail to constitute qualified research under I.R.C. § 41(d).
- These activities are often new developments, creating novel architectures and involve high technical uncertainty.
We have collated this audit guide into an easy to follow Risk Matrix, though you can browse the expanded version of the guideline for examples of each point.
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Are you developing new software for an existing application? Did you know your development work could be eligible for the R&D Tax Credit and you can receive up to 14% back on your expenses? Even if your development isn’t successful your work may still qualify for R&D credits (i.e. you don’t need to have a patent to qualify). To find out more, please contact a Swanson Reed R&D Specialist today or check out our free online eligibility test.
Who We Are:
Swanson Reed is one of the U.S.’ largest Specialist R&D tax advisory firms. We manage all facets of the R&D tax credit program, from claim preparation and audit compliance to claim disputes.
Swanson Reed regularly hosts free webinars and provides free IRS CE and CPE credits for CPAs. For more information please visit us at www.swansonreed.com/webinars or contact your usual Swanson Reed representative.