The federal R&D tax credit is a generous tax incentive available to companies that invest in the design of new or improved products, processes, software, techniques, or technologies. Surprisingly, although software and technology companies are in a sweet spot for R&D tax credit eligibility, many are unfamiliar with this tax credit and its potential impact on their tax bills.
About the R&D Tax Credit
The R&D tax credit, which was enacted in the 1980s to incentivize innovation in the U.S., can directly reduce a company’s tax bill dollar for dollar. While it is generally a non-refundable credit used to offset income taxes, some early-stage companies can use the credit to offset payroll taxes.
The R&D tax credit is calculated based on the amount of Qualified Research Expenditures (QREs) that a company incurs. QREs can include the following expenses:
- Wages paid to employees involved in R&D;
- Payments to contractors or vendors that provide R&D services;
- Materials used in R&D that are not capitalized or depreciated; and
- Payments for cloud-based development environments or resources.
To be considered QREs, expenses must be paid for activities that meet the following criteria:
- Take place within the U.S.;
- Attempt to design a new or improved product, process, software, formula, technique, or technology;
- Involve technological research (physical or computer science, engineering, biology, etc.);
- Attempt to eliminate uncertainty-related appropriate design, methodology, or capability; and
- Utilize experimentation to evaluate one or more alternative solutions.
How Much Is the R&D Tax Credit Worth?
The federal R&D tax credit is one of the most lucrative tax incentives out there. Generally, it is worth between 5% and 10% of eligible QREs. The larger a company’s investment in innovation and R&D, the larger its R&D credit.
Many states also offer their own R&D tax credit for QREs incurred within that state. The value of state R&D tax credits varies widely but generally ranges between 3% and 15% of eligible state-specific QREs.
In addition to current year R&D tax credits, companies can often claim R&D tax credits from up to three years in the past, providing an avenue to recoup previously paid taxes.
R&D Tax Credit for Software and Technology Companies
In today’s environment, innovation fuels the software and technology industry. Many activities undertaken by software and technology companies as they develop new and improved programs and features naturally meet the R&D tax credit criteria and qualify as QREs. The following list is a sample of software engineering activities that are eligible for the R&D tax credit:
- Developing functional specifications
- Performing requirements, scope, and domain analysis
- Designing new software architecture and algorithms
- Creating source code
- Performing unit, integration, performance, and regression testing
- Developing internal or customer-facing software applications
- Developing mobile applications
In many cases, most of the wages paid to the engineering department will qualify as QREs. A portion of the wages paid to the product, quality, and similar departments will also often qualify as QREs.
The R&D tax credit also applies to software developed by non-technology companies. Companies that invest in custom client portals, quote-generation engines, e-commerce platforms, servicing and delivery systems, and similar applications can benefit from the R&D tax credit regardless of the industry.
How to Claim the R&D Tax Credit
The R&D tax credit is claimed on a company’s income tax return. Before making a claim, companies must analyze their projects and activities against the R&D tax credit rules. There’s a certain level of documentation required to successfully claim the R&D tax credit, and companies that claim the credit incorrectly could be subject to penalties.
How Can Firestone Help?
Though software and technology companies are often strong natural fits for the R&D tax credit, many companies forgo the benefit because of misconceptions about the credit. Sometimes, companies don’t understand that they aren’t required to develop groundbreaking technologies in order to qualify. Startup companies don’t always realize that they can benefit from the R&D tax credit before they are profitable.
Firestone specializes in helping companies obtain the maximum available R&D tax credit. The R&D tax credit is complex; we cut through the technical tax jargon and invest the effort to calculate and support R&D tax credits in a manner tailored to the way that you run your business.
At Firestone, we use a no-risk, three-step solution that includes a free investigation. Read about this process in detail here.
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