R&D Tax Credits for Software Development Advancements in 2020 & Beyond

By Guest Contributors Tetyana Guguchkina & Tiffany Solymon KBKG Tax Credits, Incentives, & Cost Recovery

Throughout the years, software has found itself in every facet of our lives, from smartphones to smart televisions; even homes nowadays are labeled “smart.” As the software industry has grown, so too has its piece of the pie as it relates to the Section §41 credit for increasing research activities (the “R&D Credit”). Companies engaged in the development of brand-new software or the improvement of existing software can recognize a dollar-for-dollar reduction in the federal and, potentially, state tax liabilities.

The past decade has seen remarkable advancements in the software industry, which will continue to dominate the mainstream in 2020.

HERE ARE A FEW OF THE MOST SIGNIFICANT INNOVATIVE SOFTWARE DEVELOPMENT ADVANCEMENTS OF 2020:

• Blockchain • Cybersecurity • Progressive Web Apps (PWAs) • Internet of Things (IoT) • Artificial Intelligence (AI) • Connected Cloud Software • Immersive Technologies (AR/VR/MR) • Fifth Generation Wireless Technology (5G)

2020 will continue to be a gold rush for developers who devote themselves to the software development trends mentioned above. Along with the reduction of corporate and individual tax rates introduced by the Tax Cuts and Jobs Act, experts expected to see growth in R&D expenditures for existing software companies as well as a significant increase in the number of newly formed start-ups. The anticipation that these companies would take advantage of R&D tax credits due to the law changes did not disappoint.

MAJOR PATH ACT CHANGES TO THE R&D TAX CREDIT

1. The temporary nature of the credit; 2. Companies that were in a loss position could not monetize the credit; and 3. The credit could only offset regular tax liability

Due to its temporary nature, taxpayers had to sweat it out each year to see whether Congress was going to renew the credit. Since its inception, it has expired 16 times with one period where the credit did not exist. This made it difficult for companies to conduct proper tax planning, budget for resources, make financial and hiring decisions, raise proper capital, or secure debt financing. The uncertainty surrounding their taxable position made running their businesses challenging.

Then came the Protecting Americans from Tax Hikes Act (PATH Act). The Act, passed by Congress and signed by President Barrack Obama in December 2015, attempted to remove some of these barriers to claiming the R&D credit.

One of the more important achievements of the PATH Act was the permanent extension of the research credit, allowing taxpayers to plan and budget for its existence.

The PATH Act also made it possible for qualified start-up companies to receive a tax break. Traditionally, start-up companies remained in losses during early years, while developing new products and software, which prevented them from pursuing the R&D credit. The PATH Act changes now allow eligible small businesses to use up to $250,000 of research credits annually against their payroll tax liability. A qualified start-up is defined as a company with less than $5 million in gross receipts (for the current tax year) and no gross receipts for any tax year preceding the five-tax-year period ending with the tax year. For example, if a company’s first year of election is 2019, the company must not have had gross receipts in tax years preceding 2015. The election cannot be made for more than five years.

INSIGHT: The payroll tax offset offers a significant opportunity for taxpayers engaged in software development. Industries with long lead times to market that employ highly compensated employees, tend to operate at a loss, at least in the first few years. The payroll tax offset offers these taxpayers another avenue for the monetization of the credit.

Lastly, eligible small businesses can now use the R&D credit to offset Alternative Minimum Tax (AMT). An eligible small business is defined as a non-publicly traded company having an average of $50 million or less in gross receipts for the prior three tax years. Before the PATH Act, taxpayers in AMT could not utilize the R&D credit. These companies had to carry forward their tax credits and use them only when they came out of AMT. With the passage of the PATH Act, eligible small businesses can now use the credit to offset AMT.

INSIGHT: This is particularly useful for pass-through entities. Although the R&D credit is claimed at the entity level, credits flow through to the individual shareholders or partners in pass-through entities on the Schedule K-1. Before the PATH Act, individual partners or shareholders of companies could not use the credit if they were in AMT. After the PATH Act, these same taxpayers can now use the R&D credit to drop their tax liabilities below AMT levels.

WHAT SOFTWARE DEVELOPMENT ACTIVITIES AND EXPENDITURES CAN BE INCLUDED IN AN R&D TAX CREDIT CLAIM FOR SOFTWARE PROJECTS?

Companies performing qualified research, such as creating or improving software, may qualify for federal and state R&D tax credits for the software development activities they are already conducting. These credits are a dollar-for-dollar reduction in federal and state tax liability and could range from 6.5 percent to 15 percent of total research expenses. For example, a company employing ten software engineers with qualified wages of $1 million could see federal and state R&D credits exceeding $100,000 for a single tax year.

LEARN MORE 

1 H.R. 1/P.L. 115-97, “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018. 2 P.L. 114-113 Protecting Americans from Tax Hikes (PATH) Act of 2015.