What Tech Companies Claiming R&D Tax Credits Need to Know

The establishment of state-level R&D tax credits has helped spur the growth of businesses, as one research by an MIT professor shows. This research further solidifies the impact that R&D tax credit has had on businesses, particularly startups and SMBs.

Software and technology companies can capitalize on R&D tax credits because a significant chunk of their expenses goes to paying: software developers when developing and improving software e.t.c., cloud computing services, and product managers, all of which qualify for R&D tax credits.

Here’s a breakdown of how you can assess if your tech company qualifies for R&D tax credit and how you can leverage this incentive to improve your cash flow and lessen your tax burden.

Qualified Activities

A substantial number of the activities carried out by tech companies qualify for the R&D tax credit. This could go as far as simulation and testing of new technologies, devices, software, performance evaluation, architecture, and design.

Qualifying R&D expenses are loosely defined in Treasury Regulations section 1.174-2, which states, “Qualifying expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.

Simply put, these are expenses associated directly with the development of a company’s goods, services, or intellectual property.

Eligibility Test

Your company has to be eligible for the R&D tax credit before applying. For a tech company to be compliant and qualify for tax relief, its R&D activities must comply with a four-part test that determines the following:

  • The research and design are related to developing a software or product that will provide new or improved function, quality, performance, or reliability.
  • The process is undertaken to discover technological information depending on the information available to the company and its ability to develop or design the product in question.
  • The experimentation process is used to eliminate uncertainty, e.g. when data analytics are in play or during software testing e.t.c. This applies to evaluating alternatives, testing that can approve or disapprove hypothesis, or the formal testing of a product.
  • The experiments must rely on engineering disciplines and science, which include engineering and computer sciences.

Technology companies and particularly those in software development should know that merely using computer science doesn’t satisfy the criteria. However, the development of software involves simulation, modeling, and assessing the performance of the design using technical methods, thus making software development eligible for R&D tax credits.

Disqualifying activities

It’s equally important to understand some of the R&D activities that don’t qualify for this type of tax credit:

  • Routine production and maintenance
  • Software application configuration
  • Routine quality control testing and post-release bug fixes
  • Software and technology developed out of the U.S and its territories
  • Development for purely cosmetic reasons

Potential Challenges in Applying for R&D Tax Credit 

Qualifying tech companies can include various eligible expenses in their application, including wages, cloud computing costs, contract research, and cost of supplies used in R&D.

Despite the apparent benefits, some companies might decide not to claim the R&D tax credit due to several hurdles:

  • Funded research — Some products developed, whether under a work-for-hire agreement or funded by an outside party, may not meet the qualification criteria.
  • Internal use –Businesses that create custom software for their use may qualify for R&D tax, but only if the software is not marketed, leased, licensed, or sold to third parties.
  • Highly-compensated professionals –highly compensated employees don’t automatically disqualify you from the tax incentive. But they do attract additional scrutiny from the IRS to determine activity and substantiate the wages associated with the tax credit. Additional documentation like emails, R&D-related calendar appointments, and academic documentation might be required in the process.