R&D Tax Credits
for Software Development

The research and development (R&D) tax credit is a federal tax credit that is available to businesses that conduct qualified research and development activities. If your company spends money on equipment or pays employees to create something new - like software - there’s a good chance you are eligible for the research and development tax credit.

The R&D tax credit can end up saving you a ton of money, and can even be used to your advantage in other ways if you're a new or small startup.

The problem is, researching and comparing R&D tax credit companies on your own takes hours or days of research and in the end you still don’t know if you’re getting a good deal.

At Open Advisor, we work directly with R&D tax credit processing companies, so we know exactly which company will work best for you, and most importantly, where you can get the best rate.

Learn More About Getting R&D Tax Credits for Software Development

How to Know If You're Eligible: The Four Part Test
What Are Some Examples of Qualified R&D Activities in Software Development?
How to Compare R&D Tax Credit Companies and Save Money

How does software development qualify for the R&D tax credit?

The purpose of the research and development tax credit is pretty simple - to incentivize companies to invest in research and development by reducing their tax burden if they put resources towards it.

The IRS has a comprehensive 4 part test to determine what really qualifies as "research and development", but to quickly summarize, the 4 criteria are as follows:

Elimination of Uncertainty

The first part of the test is what is referred to as “elimination of uncertainty” which sounds weird, but makes sense. The idea of the R&D tax credit is to reward companies for trying to add to objective knowledge about the world, which rules out work on subjective metrics. In other words, this research can’t solely be about aesthetics or how something looks.

What they mean here is that your research and development work needs to be doing something that tells us a piece of information which we didn’t know before. This seems more obvious in the context of something like biotech research because you may be creating a new chemical compound which hasn’t previously been used.

But the same idea applies to software development - writing new software that arranges computer code in a new way is a way to eliminate uncertainty. Maintaining, fixing, automating, or upgrading software wouldn’t qualify because these are routine processes people already follow, but writing something completely new would qualify because there is no previously set path to follow.

Permitted Purpose

This means that you have to be creating one of these:

Product

Technique

Process

Formula

For the purpose of improving quality, function, reliability, or performance, which really just means making something that works and is an improvement in some way. For software, the implications are pretty clear - write code that works and makes something better.

Computer Software

Invention

Technological in Nature

This means your research and development costs have to apply to engineering or a scientific discipline, and explicitly names computer science as one of these fields.

Process of Experimentation

Like part three above, the process of experimentation is likely not something you will have to worry about as a software company. What the IRS means here is that you have to explore alternatives, or simulate other possible solutions to the problem you’re trying to solve.

For example, a software company might try several ways to create a new compression algorithm. If the development team working on this tries five ways, and only one works, or even if none of them work, these are still activities that qualify for the R&D tax credit.

R&D Tax Credit Examples for Software Companies

Some common activities startups or software companies experience that often contribute to your qualified expenses could be:

Wages for Qualified Employees, AKA Payroll Expenses.

If you have software developers working on a new algorithm that your company will use, their salaries may count as qualified expenses.
This can even extend to contractors that your company may use.
These wages or contract costs must be for work done in the United States.

Servers or Cloud Computing Expenses

If you use significant computing power or have to buy new servers to be able to adequately support your development team, these expenses may count as qualified expenses.

Testing and QA

R&D doesn’t strictly apply to creating something new, it also applies to expenses incurred in the testing or QA stages of these new products.

Other common expenses for a software company like paying for employees and resources to put together technical documentation, buying software development tools, and even portions of rent or utilities bills can sometimes count toward your qualified expenses for the R&D tax credit.

How can you use R&D tax credits?

The R&D tax credit reduces your federal taxable income. For many companies, the R&D credits simply show up as a reduced tax bill. However, there are few other nuances, especially if you are a small or new company.

If you’re a new, small startup, you might not have very much income tax liability. If you end up with credits worth more than your income tax bill, you can carry over the difference for up to 20 years. You can also use these credits to your advantage in a couple of ways:

Use your R&D credits against your payroll taxes. If your company is less than 5 years old, isn’t publicly traded, and has never had gross receipts higher than $5 million, you can use these credits to reduce your FICA taxes - even when you’re not profitable.
Because those credits carryforward for 20 years, it means they’re still usable in future years - even if the company is acquired. So say a new, small startup accumulates a lot of R&D credits in just a few years and is then acquired quickly. The buyer can use those credits in the future, so the company being acquired would be able to increase their leverage in negotiations.

Why is Comparing Companies Important for the R&D Tax Credit?

Tax credits can be extremely complicated, and the R&D tax credit is no exception. What makes the research and development credit so complicated is not necessarily just determining which activities qualify. In order to actually find and add up all of the qualifying activities, a firm must have a process for gathering that information.

Different R&D credit processing companies have different methods for determining your qualifying research expenses, and certain partners may be better suited for you based on other factors like your industry or size.

Why Should You Compare R&D Rates with Open Advisor?

"I work with a great CPA on my company's taxes and [Open Advisor] still saved me a LOT of headache...I would have paid thousands on a deposit just for 3 years worth of returns to be audited...thank you"

- Founder and Owner, Digital Marketing Startup

Compare and Save With Open Advisor

The R&D tax credit can be complicated, and the way a company goes about gathering their information and calculating the credit can make a difference, both in how much you save and how confident you can be in their assessment.

Get the lowest available rate for your company with a partner that makes sense for you.

Already have a partner in mind? Get in touch with an Open Advisor expert to see how they stack up to dozens of the top R&D tax credit processors and make sure you get the best rate.

Frequently Asked Questions about the R&D Tax Credit

What is the R&D Tax Credit?

The R&D tax credit was created in 1981 to encourage businesses to invest in research and development. The credit has been extended several times. The R&D tax credit encourages company to create new technology and invest in innovation with a dollar for dollar reduction in their tax liability.

What Qualifies for the R&D Tax Credit?

To be eligible for the R&D tax credit, your research activities must meet four criteria: 1. They must be original. This means that the research must be new or innovative, and it must not be something that has already been done before. 2. They must be technologically related. This means that the research must utilize science, enginerring, or technology. 3. They must be undertaken for the purpose of discovering information that is useful in developing a new or improved product, process, service, computer software, technique, formula, or invention. 4. They must be part of a process of experimentation, meaning this needs to be part of trying out several solutions to a problem.

How do You Claim the R&D Tax Credit?

To claim the R&D tax credit, you must file Form 6765, Credit for Increasing Research Activities, with your federal income tax return. You can find Form 6765 on the IRS website. To complete Form 6765, you will need to gather documentation of your qualified research expenses. This documentation can include: Timesheets for employees who worked on qualified research activities Invoices for supplies and equipment used in qualified research activities Contracts with third-party research collaborators Patent applications Technical reports Once you have gathered your documentation, you can begin completing Form 6765. The form is divided into four sections: Section A: General Information Section B: Alternative Simplified Credit (ASC) Section C: Additional Forms and Schedules Section D: Qualified Small Business (QSB) Election If you are a qualified small business (QSB), you can elect to claim a simplified version of the R&D tax credit. This election can be made by checking the box on line 17 of Form 6765. Once you have completed Form 6765, you can file it with your federal income tax return. You can file your tax return electronically or by mail.

How do You Calculate the R&D Tax Credit?

The R&D tax credit can be calculated using two methods: the traditional method and the ASC method. The amount of the credit is calculated by multiplying a percentage of your QREs (qualified research expenses) by the lesser of your base amount or 50% of your QREs. The ASC method is a simplified method that can be used to calculate the R&D tax credit. Figuring out the correct method is one of many considerations when applying for an R&D tax credit.

What is the R&D Credit Carryforward?

The R&D credit carryforward is a provision of the tax code that allows businesses to carry forward unused R&D tax credits to future tax years. This means that if your business does not have enough taxable income in a given year to claim the full amount of your R&D tax credit, you can carry the unused credit forward to future years. The R&D credit carryforward can be a valuable tool for businesses that invest in research and development. It allows businesses to offset their tax liability in future years, even if they do not have a profit in those years. The R&D credit carryforward is limited to 20 years. This means that if you do not claim your unused R&D tax credits within 20 years, they will expire. Here are some of the benefits of the R&D credit carryforward: It can help businesses offset their tax liability in future years. It can help businesses stay competitive by allowing them to invest in research and development without having to worry about the immediate tax implications. It can attract new investors and customers by demonstrating a company's commitment to innovation.

Is Software Development Eligible for the R&D Tax Credit?

Yes, software development can be eligible for the R&D tax credit. The credit is available for businesses that conduct qualified research and development activities, and although this process is different in software development than for manufacturing or biotech, but software development companies often qualify without knowing it. Look to the question "What qualifies for the R&D tax credit?" to get an idea of the eligibilty guidelines.