KUTCHINS,
ROBBINS &
DIAMOND,
LTD.
WHITEPAPER: R&D TAX CREDIT FOR SOFTWARE DEVELOPMENT
Decoding the R&D Tax Credit Translates
into Generous Savings and Refunds for
Lead Generators, LMS Providers, &
Consumer Data Reporting Firms
WHITEPAPER: R&D TAX CREDIT FOR SOFTWARE DEVELOPMENT
Decoding the R&D Tax Credit Translates into Generous
Savings and Refunds for Lead Generators, LMS Providers,
& Consumer Data Reporting Firms
The development of computer software requires innovation. It requires incredible skill and an enormous amount of experimentation. Systematically creating code, testing, determining ways to improve performance, and refining to achieve maximum efficiencies are all bedrocks of software development. And they are the very behaviors that are both domestically and internationally recognized as critical components to economic development and global competition.
In 1981, in the wake of a recession, Congress enacted a tax credit designed to reverse the accelerated trends of a diminishing domestic ability to compete with foreign markets. Thus began the American investment in "research and development."
The Credit for Increasing Research Activities, more commonly known as The Research and Development (R&D) Tax Credit, has broad bipartisan support in Congress, as illustrated through 30 years of progressive expansion, refinement, and more than a dozen renewals. Today, the United States assigns nearly $9 billion a year in federal R&D Tax Credits, making it one of the most lucrative tax incentives available in this country. In addition, more than 30 states offer their own version of the credit. In some States there are fewer limiting factors and a wider scope for which the credits may be applied, thus doubling and tripling the overall benefit and impact when captured in conjunction with the federal credit.
The concept of R&D usually conjures up visions of white lab coats and microscopes, but those instruments of invention don't generally come in handy when writing hard code. As a result, many software companies are unaware that the government offers incentives for engaging in activities that are often misclassified by programmers as "just another day in the office." Additionally, those who are aware of the R&D credit often lack the proper expertise and guidance, and consequently fail to capture and/or support all eligible expenses. The myth that the R&D credit is only propagated in laboratories where groundbreaking innovations or patentable products are the focus comes from the fact that for the large majority of its existence, that was a relatively accurate depiction. The traditional definitions and the tax definitions of R&D were nearly synonymous. Congress recently recognized, however, that restrictions such as the Discovery Test had been limiting the credit's ability to fulfill its purpose for small and medium-sized businesses. Navigating through another recession, it was again determined that investing in R&D would expedite our recovery, so the Discovery Test was thrown out along with a documentation requirement in an effort to stimulate economic growth.
Today, for software developers, one simply needs to develop new or improved software features or
functionality and go through a development process (agile, waterfall, prototyping, spiral, RAD, etc.) in order to qualify.
For illustrative purposes, we turn to a lead generation firm (LeadGenCo) for whom the R&D credit was claimed for a six-figure refund. LeadGenCo employs teams of programmers who develop lead generation software and perform quality assurance tests. It also employs analysts, project managers, and executives who engage in the conceptualization process and/or the supervision of the programming teams. Their development stage using the waterfall development methodology began with a requirements definition, then moved onto specification, system and software design, implementation and unit testing, integration and systems testing, acceptance testing, and eventually settled into operations and maintenance.
Do Your Activities Pass the Test?
As with any benefit offered by the government, there are requirements that every business must meet in order to qualify.
For the R&D Tax Credit, there is a four-part test:
1. There must be an attempt to develop a new or improved business component1(e.g. software). 2. It must be technological in nature.2
3. There must be a degree of uncertainty. 4. There must be a process of experimentation.
1) New or Improved Business Components
The U.S. Tax Code describes six elements that qualify as Business Components: products, processes, techniques, inventions, formulae, and computer software.
To qualify, the goal in the development of the software must be to create new or improve existing functionality, performance, reliability, or qualities (a "permitted purpose").3 The most obvious qualifying projects are the newer ones, and with some companies, it is apparent that the tests easily will be met. If the software programming and development supports the creation of new business components, it is a simple case to support the notion that a project containing a new software module would qualify.
And while the development of new programs is worthy of focus when capturing the R&D credit, one should not overlook the development of improved software. When a new software module is ready for its intended use, by no means is the development complete. In fact, it may never be. Companies take small steps,
improving a product or process gradually. Think about how many updates a single iPhone or Android app goes through. The developers are fixing bugs, improving performance and processes, adding new features, and refining the way it communicates with the hardware and other apps. As long as there is an improvement of the software program or a creation of something entirely new, and if the work is aimed at a permitted purpose, it will satisfy the New or Improved Business Component test.
LeadGenCo enhanced existing software to improve its processing ability. It also expanded the types of data that the system could handle. These improvements were for a permitted purpose -to improve the functionality and performance of the software. Not everything it did was ultimately considered qualified for R&D, such as cosmetic changes to an interface and syntax error corrections (activities which related primarily to style or
1
Treas. Reg. 1.41-4(a)(1).
2
Treas. Reg. 1.41-4(a)(2)(ii). 3 Treas. Reg. 1.41-4(a)(2)(iii).
taste were not eligible for the credit4), so the wages tied to those hours were not applied. However, there were significant hours left to capture because of the type of programming in which the company was engaged.
2) Technological in Nature
The goal of the R&D credit is meant to incentivize technical, scientific, and engineering-based activities. Programming naturally relies on principles of computer science, making this an easy test for software companies to pass.5
Examples of developmental activities eligible for R&D tax incentives:
• Developing new or improved technologies
• Developing requirements, domain, software elements, or scope analysis for a new functional software enhancement
• Evaluating and establishing functional specifications
• Designing and developing the structural software architecture
• Establishing electronic interfaces and functional relationships between various software modules
• Programming software source code
• Compiling and testing source code
• Conducting unit, integration, functional, performance, and regression testing
3) Uncertainty
Defining the uncertainty faced within a project can be complex. Under current regulations, the uncertainties faced should be identified at the outset of a research project.6Itwill be determined that "uncertainty exists if the information available to the taxpayer does not establish the capability or method of developing or improving the business component, or the appropriate design of the business component."7
In software development, there are a wide variety of situations where uncertainty may occur. Though there may not always be significant uncertainty regarding the capability or method of developing a new or improved software program, there is typically uncertainty as to the most efficient design. The key is that all three types of uncertainty need not exist; anyone area will qualify on its own. Software developers often think about and address design uncertainties through coding exercises. A company may not know the most efficient way to process data or to access a database stored on a remote server, so they might run through a series of sprints to maximize the efficiency of the module, to minimize the number of network calls, or to ensure the data is efficiently decrypted and re-encrypted.
LeadGenCo was uncertain in regards to the architecture of the software and went through an iterative process to determine the most efficient workflow in its applications. In addition, they were uncertain as to how new features should be best integrated. These design challenges were present until the company was able to successfully build out a full prototype, put the system under a simulated high load, and evaluate/verify successful results.
4 Treas. Reg. 1.41‐4(a)(S)(iii). 5 Treas. Reg. 1.41‐4(a) (4).
6
See Treas. Reg. 1.41-4(a) (3) (i).
7 Id.
4) Process of Experimentation
For research to be considered qualified, there must be a process of experimentation to attempt to resolve its uncertainty regarding the development of the business component.8"A process of experimentation is a process designed to evaluate one or more alternatives to achieve a result."9 For example, it may include modeling, simulation, or a systematic trial and error methodology.10 Software development is inherently a process of experimentation. Development processes are built upon varying frameworks, but all involve building out a program (a hypothesis), building out a prototype, testing it, evaluating it, determining how and why it didn't work (since it never works perfectly the first time), and then repeating that cycle.
When evaluating R&D eligibility, companies should focus on the steps taken to eliminate the uncertainties identified above. Equally important is to understand how a prototype solution is evaluated, what was learned from the first experiment, and how this knowledge was applied in the next sprint or the next iteration of the waterfall. Software programmers often think about their work on a higher level: “l worked on XYZ module." With respect to this test, an in-depth examination for the most information possible is recommended. LeadGenCo went through the waterfall process numerous times with every incremental improvement in its software. As they identified new issues, developers tracked the problems/challenges and the ultimate resolutions in a defect database. When it achieved stable versions of the applications, a team of quality assurance analysts tested them thoroughly to ensure that each module retained individual functionality while still functioning as part of the whole. Since it participated in concept development, testing and programming activities, whereby it eliminated alternative design approaches, the company's development path constituted a process of experimentation.
What Can Be Expected?
Because much of what LeadGenCo was involved with satisfied all four tests, the development met the requirements for the R&D Tax Credit, and the company is now reinvesting and protecting its assets. The original study yielded six-figure refunds, since all open tax years are were able to be revisited.
Every company is different. There are different industries, different owners, different employees, different business models, different products, different geography, different clients, etc. The R&D Tax Credit will apply accordingly.
How Do You Claim What You Deserve?
This is one of the most important questions. Identifying an opportunity for the R&D Credit is only the beginning. The quantification and detailing of the value, and, of course, the proper substantiation for
capturing the credit requires a deep understanding of the Tax Code, the intent of the law, and an equally deep understanding of the industry being served. For this reason, specialty tax firms exist to help their clients capture this powerful incentive.
8
See IRC § 41(d)(1)(C). 9
Treas. Reg. 1.41-4(a)(S)(i).
10 See Id.
It's a Moving Target ...
Since enactment in 1981 as a part of ERTA (Economic Recovery Tax Act), the R&D Tax Credit has undergone an abundance of developments, many of which have occurred within the last decade. From throwing out the Discovery Test to the Alternative Simplified Credit, a base calculation alternative, the changes have been expansive both in the size of the credit and the areas to which it can be applied. Other limiting factors, such as the Alternative Minimum Tax (AMT), that have precluded companies engaged in the appropriate activities from taking the credit, have also changed in recent years. Just like a software module requires continued review and improvement, so does the capture and substantiation of one's R&D Credit. Those already claiming the benefit should be concerned with old rules versus new rules, case law, and general direction from the Internal Revenue Service. The expansions have purpose and are weighted with higher payouts to encourage further domestic technological advancement.
With the growth of the credit comes an increasing need for comprehensive checks and balances to ensure the resources are being properly distributed. These complexities, particularly when considering the nature of what's at stake (i.e., your business), are to be thoroughly understood when applying the R&D Credit. Appropriate tax professionals should be consulted who have specific knowledge of this industry.
Authors and Contact Info:
Robert Wonish II, J.D. – Alliantgroup, Associate Director of Tax Controversy, Houston Office. Robert Wonish is
an Associate Director in the Tax Controversy Services division of alliantgroup, providing advocacy for companies that come under federal of state tax audits for credits determined by alliantgroup, as well as credits determined by outside tax service providers. He is a graduate of the South Texas College of Law.
Luke Hammon – Alliantgroup, Associate Director, Irvine, CA. Contact him at (949) 271-8854 or
Tom Duffy, CPA – Kutchins Robbins and Diamond, Ltd, Greater Chicago, IL. Tom focuses his practice on tax
planning and consulting for online lenders engaged in domestic, offshore and tribal lending. He also specializes in the tax incentives offered through the U.S. Virgin Islands EDC program. Tom is a frequent tax lecturer at various PDL conferences around the U.S. Contact him at (847) 278-4381 or [email protected]
Al Kutchins, CPA – Kutchins, Robbins and Diamond, Greater Chicago, IL- Al is the founding partner of KRD,
CPAs. Al specializes in tax and estate planning for online lenders. Al and his team at KRD take a holistic approach in helping their clients preserve their wealth. Contact him at (847) 922-9414 or [email protected]
