The R&D Tax Credit and the software industry complement each other but companies need to know what activities are potentially qualified in order for them to take full advantage of these benefits and opportunities.
According to the Internal Revenue Code (IRC), “software” is considered a business component for R&D Tax Credit purposes. Under the new final regulations for internal use software (software developed primarily for the taxpayer’s internal use, e.g. general and administrative functions), qualified research activity eligible for the R&D Tax Credit must satisfy the three-prong, high-threshold-of-innovation test in addition to the standard four-part test. Whether software will be considered to be developed primarily for internal use depends on the intent of the taxpayer and the facts and circumstances at the beginning of software development.
Software is not developed primarily for internal use by the taxpayer if the primary objective of use is for funtions other than general and administrative actions that facilitate or support the conduct of a taxpayer’s trade or business. The final software regulations provide two specific examples of software that is not internal-use software under this rule:
- Software developed to be sold, leased, licensed, or otherwise marketed to third parties; and
- Software developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system.
The development of such software may be eligible for the R&D Tax Credit if the development activities satisfy the more broad and general definition of research under the four-part test. In any case, taxpayers need to evaluate their software development projects to determine which types of software their company is developing (internal-use or client facing)?
Payroll Tax Offset for Start-Up Companies
In general, to take advantage of the R&D Tax Credit, companies need to have income tax liability however, recently enacted legislation allows certain start-ups and small businesses to use the federal R&D Tax Credit against their federal payroll tax liability (FICA), whether or not taxpayers have income tax liability. As a result, non-income tax paying businesses who previously could not benefit from R&D Tax Credits, can now improve their cash flow by as much as $250,000 per year by claiming these credits.
Many new software companies are qualified small businesses (QSB) if they have gross receipts less than $5 million for the credit tax year and had zero gross receipts prior to the five-tax-year period ending with the credit tax year. For example, a software company founded in tax year 2013 would be eligible for a federal payroll tax offset for tax year 2017. The R&D Tax Credit must be claimed on an originally filed tax return (including extension) and once you make the election you can use the credit to offset future payroll tax liability.
For new software companies, this law allows taxpayers to receive a generous tax benefit even if still incurring significant operating losses as the business ramps up operations for future revenue, profits and tax liability.
For more information on tax incentive programs available in your area, find your state below.