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The software industry is notorious for overlooking qualified research expenses for the R&D tax credit. Often, companies aren’t aware that their business is incurring research expenses and/or have overlooked possible research activities being conducted each year.
Tax incentives and credits are an important opportunity for companies to develop and grow their business. One of the most lucrative tax credits offered today is the research and development (R&D) tax credit, which allows companies to offset federal and state income tax liability when incurring software R&D expenses.The following are five of the most commonly overlooked qualified research expenses in the software industry:
Many companies don’t just develop software products for sale to clients or customers. Software development companies also create internal-use software to be used primarily for operating their business.
The following are additional requirements that need to be satisfied to treat your internal-use software development activities as eligible research and experimentation expenditures for the R&D tax credit.
It is common for corporations to hire third-party software developers when conducting research and development activities, and the associated expenses are often overlooked since the consultants are not employees of the corporation.
When contractors perform research for your software development, you may incur both expenditures that would constitute qualified expenses and those that would not. For example, wages paid to a contractor would qualify, but travel expenses or paying rent would not.
As companies look to claim R&D tax credits for their software development activities, one often overlooked expense is payments made to consultants or contractors performing research activities for the company.
This qualifying expenditure for contract research expenses is defined under IRC §41(b)(3)(A) as 65% of “any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer).”
As more and more companies invest in software development activities to operate their businesses – especially in providing goods and services to third parties – many of these activities should be considered eligible for research credits.
The following explores these circumstances, along with the high threshold of innovation requirements for capturing R&D tax credits.
One of the most lucrative incentives for companies that invest in R&D activities is the federal and state R&D tax credit. However, without the proper internal controls and procedures in place, documenting and maximizing these credits is challenging.
Where To Begin Your R&D Tax Credit Journey
Before you start evaluating your R&D activities, you must first fully understand the unique facts and circumstances of your research. At the outset of any research project, it’s important to map out your current accounting procedures that track potentially qualified research expenses.
Some pharmaceutical companies use formal project accounting, while others track expenses by cost center or departments. Based on these findings, a customized approach to capture qualified research expenses can yield good results and make the process of handling the workflow much more manageable.
With the right process in place, you reduce internal staff hours as well as the R&D service provider costs needed to document and calculate these tax credits.
Are You Waiting Until The Fiscal Year Ends?
It’s not uncommon for a company to rush an R&D tax credit evaluation, where internal accounting personnel are under significant time constraints and manpower to properly analyze costs.
Frequently, pharmaceutical companies wait until their fiscal year ends to even consider evaluating and documenting their qualified research expenses. This approach yields inconsistent and inadequate results that do not meet the IRS’s recordkeeping requirements to sustain the R&D tax credits.
Do not wait until the end of the year to review R&D activities and expenses. You want to set up procedures at the beginning of the year to regularly track, monitor and organize your types of R&D activities and costs that meet the tax credit’s eligibility requirements.
Although the R&D tax credit was created for industries like the pharmaceutical industry, especially in drug discovery and development, many pharmaceutical companies still aren’t taking advantage of this business incentive.
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