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. Only a portion of the amount paid to a contractor is considered a qualified research expense, and equals 65% of any amounts paid or incurred by non-employees for the performance of either:

• Qualified research
• Services that would constitute qualified services 

If your company uses external third-party software developers to perform research and development activities, it’s critical that you review the consulting agreements for some important contractual language. 

Qualifying Research Expenses For Contractors

An expense is to be paid for the performance of qualified research if three important conditions are met. The agreement must:

1. Be entered into prior to the performance of the qualified research
2. Provide that the research is being performed on the behalf of the taxpayers
3. Require that the taxpayer bear the expense even if the research is not successful

The most basic and best type of software development contract for the R&D tax credit is one where the consultant is paid on a “time and materials” arrangement. 

For example, a corporation hires a software engineer to design and test some experimental software code. The consultant incurs 50 hours of time on the project and bills the client based on their standard hourly rate per hour. The consultant will be paid for time incurred and the taxpayer will bear the expense of the services.

Often, these types of contracts are “works for hire,” in which the work the consultant performs becomes the property of the corporation paying the consultant. Therefore, the corporation will have rights to the results of the work being performed on its behalf and can treat the payments made to the consultant as qualified research expenses.

Pay close attention to termination clauses in software development contracts to determine if any of the payments made to the consultant can be recouped.

Sometimes, companies will pay an advance to a software development company (e.g., third-party mobile gaming developer). If the developer does not meet certain milestones agreed upon during the project, the taxpayer paying for the services may be able to recoup the advance payments, as the developer is in breach of the contract.

If your company pays third-party software developers or consultants to help you perform your research activities, consider all of the factors that need to be satisfied to treat these costs as qualifying “contract research expenses.”

When in doubt, consult with an R&D tax credit expert that will answer any questions you have and give solid guidance.

Ready to learn more about your qualifying research expenses for R&D tax credits? Download your complimentary, educational guide.