Research and development occurs in computer software work that attempts to produce an innovation or a breakthrough in the area of information technology or computer science. A step forward in these areas means an enhancement of general knowledge or capability and not simply an enhancement of a firm’s individual knowledge or capability, except in cases where the specifics of the innovation are unavailable to the firm because of proprietary concerns.

The nature of innovations in software development

Typically, an innovation or advancement in computer software development involves research on novel software constructs or architectural procedures. If present, a breakthrough in software development activities usually occurs at the algorithmic, architectural, or design level. If an innovation is to come about, the goal of the project must transcend standard analysis, modification, or copying of a company’s current software products or processes.

In the area of computer software, such an innovation is seldom inherent in a product. For example, a novel or enhanced management information system (MIS) does not constitute a breakthrough or advance in science or technology.

The breakthrough arises not from the application level but from the level of technology. In other words, it is the fact that the science or technology needed to be improved in order to develop the application that qualifies it as research and development (R&D).

Recommended Read Analyzing Research and Development Costs: A Guide for New CPAs

Tax relief eligibility can be determined by referring to R&D guidelines

By studying the R&D guidelines for software development ventures, software firms can determine if their software expansion work meets the criteria for being considered an R&D activity, as well as if the work qualifies for tax relief via the R&D tax credit. Software can become qualified for improved R&D tax relief if it is shown to be one of the following.

  1. The means by which to accomplish the R&D, or
  2. The main focus of the R&D.

Software that is used as a means to an end in a greater R&D project

In cases where software is built as an instrument or a means for specific application in a broader R&D effort, work on the software will meet the requirements as an example of R&D. A case in point would be information-handling software that is required for logging and checking the ultimate outcome of the R&D.

The software does not in itself need to relate to an explicit step forward in the areas of science or technology; if it is simply a factor in a larger R&D effort it will meet the criteria as an example of R&D.

Work on the software as the objective of the R&D effort

Software needs to be treated in the same way as other types of technical or scientific pursuits. Thus, the tax exemption guidelines are applied to a software effort in the same way they are applied to any other kind of technological venture. More specifically, the developmental work has to meet all of the following conditions.

  • The effort should try to produce a step forward in the areas of science or technology.
  • The efforts that directly contribute to achieving the step forward by resolving some area of scientific or technological uncertainty constitute a form of research and development.
  • The work needs to result in an advancement of general knowledge or competence in a scientific or technological field, not simply the software firm’s individual level of knowledge or expertise alone.

Moreover, it is important to recognize the following facts.

  • The production of a piece of software does not correspond to an improvement in an area of science or technology purely for the reason that it is software.
  • Standard modification of one of the company’s existing products or processes does not represent an example of R&D.
  • Putting together a program’s constituents based on a custom model or employing well-established techniques for doing so does not constitute R&D.
  • However, merging existing technologies may be considered R&D if a knowledgeable expert in the field is unable to easily determine how the individual elements should be merged to produce the desired function.

The majority of software projects that are eligible to be considered R&D efforts will be meant to produce a product that is either utilized in-house, licensed, or put on the market.

However, this does not mean that all costs accrued in developing marketable products will be eligible in their entirety. Only those costs generated in resolving technological issues will qualify. Later expenses encountered in creating a saleable product might not meet the requirements. Software R&D could involve research in areas such as the following.

  • Computer science theory
  • Novel operating systems
  • Cutting-edge search engines employing new ways to conduct searches
  • Innovative programming languages
  • Major technical improvements in algorithms
  • Novel or improved data query languages 
  • New or enhanced object representations 
  • Innovative encryption or security techniques that go beyond established methods
  • Resolution of conflicts in hardware or software where a problem area and the lack of a solution have been documented
  • Software engineering strategies for enhanced computer programs and AI

In this setting, artificial intelligence might relate to technical improvements in areas including robotics, expert systems, artificial neural networks, machine vision, machine translation, and the comprehension of natural language.

Thus, the production of an innovative natural language interface for a video game may well qualify as R&D, although the game itself may be an established product and may not reflect an R&D endeavor in nearly all other ways.

Learn how a software development firm saved $700,000 on R&D

Software projects that are considered R&D

The following software development activities will typically pass the IRS’s four-part test which determines whether or not research and development activities qualify for the R&D tax credit.

  • Concept development/brainstorming alternatives
  • Requirements/feasibility analysis
  • Alpha/beta testing
  • Architecture design
  • Proof of Concept/writing test code (prototype)
  • Programming/coding
  • Regression testing

Additionally, it is important to note that the R&D tax credit can be made available for activities related to software that is designed for internal use. Software does not have to necessarily be designed for commercial sale or third-party use (like the examples listed above).

In order to qualify for the R&D tax credit, internal use software must pass the High Threshold of Innovation test. Examples of internal-use software that may qualify for the R&D tax credit include the following.

  • MRP/ERP
  • Payroll/Billing
  • Warehouse Management Systems
  • HR

If you have any inquiries or need help determining whether your software development activities will qualify for the R&D tax credit, reach out to the team here at Tri-Merit by emailing us at info@tri-merit.com or giving us a call at (847) 637-5677.

Software projects that are not considered R&D

Standard software-related projects are not considered R&D. Such projects include work on system- or program-specific advances that were widely accessible before the work began. Technical issues that have been resolved through earlier efforts on the same operating systems and computer architecture are not included, nor are activities such as the following.

  • Providing technical support for currently functioning systems
  • Changing and/or translating existing computer languages
  • Enhancing user functionality with respect to application programs
  • System debugging
  • Making adaptations to currently used software
  • Producing user-related documentation
  • Producing software that duplicates a traditional paper procedure. The act of simply automating a task that was formerly done manually does not in itself constitute R&D
  • Putting together, doing routine operations on, and presenting data
  • Using customary techniques of security verification, data integrity, and encryption

Firms doing eligible research in producing or enhancing their software might qualify for federal and state R&D tax credits for the work they are already performing. These credits offer a dollar-for-dollar reduction in federal and state taxes ranging from 6.5 to 15 percent of overall research operating costs.

Tri-Merit can help you claim the R&D tax credit

There’s no denying that it can be difficult for companies to qualify for R&D tax credits and file valid R&D tax credit claims. You may need to review your internal processes, and you will have to thoroughly document any research-and-development-related activities so that they can hold up to strict IRS scrutiny.

At Tri-Merit, we have helped numerous companies file tax credit claims for software R&D, as well as a myriad of other types of research and development projects. We can help you adequately and accurately document all of your R&D activities, help you determine what qualifies as R&D and what does not, and help you achieve a significant tax saving.

Email us at info@tri-merit.com or give us a call at (847) 637-5677 if you have any inquiries or take a look at our R&D tax credit services to download our 8-point checklist to help you find the right specialty tax partner or to schedule a FREE discovery call.

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