The Internal Revenue Code (IRC) includes “software” as a business component for R&D tax credit purposes. However, the type of software development determines the level of legal tests that must be satisfied (i.e., the four-part test or additional three-part test) for software development activities to qualify for the credit. Assuming that your software development activities qualify, what type of documentation is needed to support these qualified activities?
Treasury Regulations 1.41-4(d) state that “a taxpayer claiming a credit under IRC Section 41 must retain records in sufficiently useable form and detail to substantiate that the expenditure claimed is eligible for the credit.”
Documentation is a vitally important aspect of claiming R&D activities and expenses for the credit. That’s why the IRS developed audit technique guidelines (ATGs) specifically for software development R&D tax credit claims.
Software project R&D documentation can take many forms.
One key is placing emphasis on describing the technical challenges the software development team faced at the outset of the project initiative, as well as detailing the process of experimentation that was performed to overcome those challenges.
A typical software development life cycle involves the following development phases:
- Design and functional requirements
- Design and architecture of the software system
- Programming and coding
- Alpha and beta testing
- Recode and retest
- Verification and validation
- Implementation of a release
- Executive presentation for the software development project
- Source code
- User requirements report
- Emails describing technical issues
- Quality assurance (QA) test plans
- QA test implementation
- QA testing data
- Release notes
- Code defect notification and resolution report
- Software development department mission statement
- Patent application or granted patent
One of the important aspects of gathering research documentation is to link the R&D activities to the research documentation. For example, it’s helpful to have the software engineers and developers named on the R&D documentation as either the authors of the document or as being present during a technical meeting or discussion.
An example of how easy it is to be denied an R&D claim:
On a recent audit, the IRS disallowed qualified software engineer time attending technical meetings because the taxpayer could not show that the software engineers actually attended these meetings. Having meeting minutes or calendar meeting entries would’ve been adequate documentation to meet the auditor’s skepticism that the engineers attended these meetings.
The IRS is more likely to accept your R&D tax credit claim when substantial nexus exists between the qualified research expenses and the documentation generated during software development activities. Properly documenting for software development R&D tax credit claims is the only way to capture these substantial credits and also maximize them.
Need more guidance on creating the right documentation to capture R&D tax credits for your software development? Download your complimentary, educational guide.
