Does software qualify for R&D tax credit?

The US Congress has approved an extension through 2022 that will allow businesses to claim a 20% tax credit on the full cost of their qualifying R&D expenditures. The new law also includes provisions allowing employees to claim a similar amount when they work with a company’s own data or other intellectual property.

This means that some types of software can now qualify as “internal use software,” which in turn allows developers and consultants who create it to receive a refundable tax credit. If you want to know whether your business might benefit from this type of R&D tax credit, keep reading below.

What is internal use software?

Internal use software refers to any kind of computer code created by a person employed by another company (or individual) instead of sold directly to customers. This could include custom-built apps, scripts, algorithms, or even entire websites. Internal use software doesn't have to do anything specific—it's just used internally within the same organization. It can range from simple tools like spreadsheets to complex systems such as ERP platforms.

In most cases, if you're making internal use software, you'll need to register its creation with the IRS before claiming the R&D credit. You'll then get a Certificate of Registration (COR), which includes information about what was developed (such as name of program, date, etc.), where it was built, and details about the people involved.

If you don't already have one, you should apply online at irs.gov/cor/. Once registered, you can submit a COR report anytime during the year using Form 8825, but only once per fiscal year. However, if you make changes to the software after registering it, you must resubmit a new form each time.

Who qualifies for R&D credit?

Anyone who makes internal use software can potentially claim an R&D tax credit, provided that they meet certain requirements. These are laid out under Section 174(a)(1) of the Tax Code, which states that "any taxpayer engaged in scientific research or experimental engineering shall be allowed as deductions... all reasonable allowances... paid or incurred" for R&D purposes. A key part of this definition involves being "engaged in scientific research or experimental engineering."

However, not everyone meets this requirement. For instance, independent contractors working for an employer aren't considered employees, so they won't be eligible for the tax credit. Similarly, anyone whose primary job isn't creating R&D would also miss out.

There are two exceptions to these rules. First, self-employed individuals with an annual income of $100,000 or less and no earned income from investments can still claim the credit. Second, there's a higher threshold for small businesses called the High Threshold of Innovation Test.

Basically, if you've been developing innovative technologies since 2007, you can claim the credit regardless of your employment status. To figure out if you pass this test, look back five years ago and see if you were actively pursuing the development of something innovative. If yes, you passed!

What activities qualify for R&D?

You don't necessarily have to develop the actual thing itself. In fact, the IRS specifically mentions the following three kinds of activity in defining R&D:

Contract Research - Any kind of contracted research done by an outside party. Examples include consulting firms conducting surveys or testing products for a client, universities doing studies for private corporations, or academic researchers performing experiments for various organizations.

Supplies - Anything needed to perform routine tasks associated with R&D. Examples include paper clips, coffee filters, staples, and glue.

Employee Wages - Payroll costs related to developing R&D projects.

These definitions cover both direct costs and indirect ones, meaning that everything from salaries to office equipment counts towards qualifying R&D expenditures. While you probably wouldn't be surprised to hear that payroll costs count toward the R&D credit, it's worth pointing out that this applies to both salaried workers and hourly wage earners. Companies often pay for things like software licenses via salary rather than purchasing them outright. If you spend money to license software, you're entitled to claim the credit.

Are guaranteed payments eligible for R&D credit?

One final point to note about the R&D tax credit is that employers can actually take advantage of the credit without having to prove that every dollar spent on it was tied to a specific project. Instead, they simply have to show that enough money was spent overall to justify taking the credit.

To find out how much you'd owe, download the R&D Credit Calculator Excel Spreadsheet. From here, fill in the columns marked "Wage Type" and "Cost Base," respectively. Then enter the total number of hours worked by each employee multiplied by their hourly rate. Finally, add up those numbers across all employees to determine what the total cost base would be.

From there, follow the instructions in the table above until you reach Step 4, where you plug in your values into the equation. On the next page, select the option labeled "Guaranteed Payments" and enter 0.00. That way, the calculator automatically assumes that none of the R&D credits claimed are guaranteed payments. Otherwise, you'll end up paying too little.

Once you input your figures, click Calculate and wait while the formula runs. When it comes back with a value, divide that whole number by 100 to come up with the percentage of your total R&D costs that qualify for a credit. Remember, however, that this calculation doesn't account for any potential credits you may have missed due to failing the High Threshold of Innovation Test.

If you think you qualify for the R&D tax credit, read our guide to calculating your tax return for 2021, which explains exactly how to go about filing your taxes. And remember that this tax break expires on December 31st, 2022. So if you plan on spending big bucks on R&D before then, you better start planning right away.

How does the IRS define \"qualified\" R&D expense? 

A “qualifying expenditure” is any R&D investment made in order to develop a product, process, invention, or technique that meets one or more criteria.

Must have been completed by March 30, 2020 (the end date was extended from September 30th)

Be related to the development of products, processes, inventions, techniques, or improvements in existing products, processes, inventions, or techniques used in business operations

Not be considered experimental

Have not previously been claimed as eligible

Be directly connected to the creation of tangible goods or services

To meet these requirements, the company must show that it spent at least 50 percent of its total R&D spending during the year on efforts that relate to developing products, processes, inventions, techniques, or improvements in existing products, processes, inventions, or techniques used in business operations. In addition, the taxpayer must document how the project relates to the development of tangible goods or services.

Ineligible costs are those that don’t meet either of the above two criteria:

Are experimental projects – which means that they were carried out solely for testing purposes and did not result in the production of tangible goods or services

Are indirect investments such as salaries paid to consultants, contractors, outside lawyers, etc.

(For example, if you hire a consultant who develops your web site, then you can deduct 100% of all the money you spend hiring him.)

The United States has been using an annual federal tax deduction to help cover R&D expenses since 1982. The US Congress passed legislation that allows taxpayers to deduct 20 percent of their income from qualified R&D expenditures on goods or services acquired during 2016. This deduction was expanded by President Trump’s Tax Cuts & Jobs Act (TCJA) signed into law on December 22nd, 2017.

In 2020, these deductions are being doubled under the new tax code. While this increase will have the effect of lowering individual incomes, it also means more money coming back to American businesses and workers through increased investment and job creation.

So what exactly qualifies as R&D spending that can make you eligible for the tax break? And how do you know whether your company spends enough to claim the full amount? Here's everything you need to know about qualifying for the R&D tax credits.

What is included in wages for R&D credit?

To start with, there are several types of wages that count towards R&D credits. These include wages paid to employees who are working on qualifying projects, wages paid to independent contractors performing work directly related to the project, and any other type of wage not already covered such as tips or bonuses.

For example, if you pay $5,000 per year to your office manager but she spent all her time managing the payroll department rather than doing actual R&D work, then only half of her salary would meet the requirement. But if her boss decided to give her a bonus based solely upon the success of the company, then both her salary and bonus could qualify.

While some people might argue that paying someone extra because they're good at their jobs doesn't really qualify as "research," many experts agree that providing additional compensation to an employee for completing tasks related to the company's goals counts toward the 20 percent R&D expense cap.

What industries qualify for R&D tax credit?

Because the purpose of the R&D tax credit is to encourage innovative thinking within corporations, certain industries are considered especially deserving of support. Some examples include aerospace manufacturing, defense industry, pharmaceuticals, electronics, information technology, biotechnology, chemical production, computer hardware, food processing, medical equipment/devices, energy conservation products, and telecommunications equipment.

There are also specific exemptions for smaller businesses operating in these fields as well as those that sell less than $50 million worth of goods annually. For instance, if you run a restaurant chain with eight locations across five states, each location must generate sales of $1 million before you receive the benefit of the R&D tax credit.

If you want to learn which industries are most likely to get the maximum benefits from the R&D tax credit, check out our list of best tech stocks.

Who is eligible for the R&D tax credit?

Anyone running a qualifying small business can apply for the R&D tax credit, including sole proprietorships, partnerships, LLCs, S-Corps, 501(c)(3) organizations, nonprofits, and public K-12 schools. However, if you belong to one of these groups and you don't actually own the majority of the company assets yourself, you'll still be required to report your share of the profits and losses generated by the business on your personal taxes.

This means you won't be able to take advantage of the tax credit without first filing separate IRS forms with the names of all partners, shareholders, board members, etc. If you'd like to find out more about reporting requirements, you can visit the Internal Revenue Service's page detailing how to file your taxes.

Additionally, individuals living outside of the U.S. cannot use the R&D tax credit unless they are employed by a qualifying small business located inside of the country. So even though you've worked hard throughout your career earning a degree abroad, you probably aren't going to see much tax savings when you retire down the road.

But hey, maybe next time!

What is a qualified small business for R&D credit?

A qualified small business is defined differently depending upon where you live. In general terms, however, a qualifying small business is determined by its total revenue over three years. A higher dollar figure indicates a larger business while a lower number suggests a smaller enterprise.

Here's a quick breakdown of the various thresholds for different regions:

California: $25,000,000

Colorado: $10,000,000

Connecticut: $15,000,000

Delaware: $7,500,000

District of Columbia: $2,000,000

Florida: $20,000,000

Georgia: $8,750,000

Hawaii: $4,250,000

Illinois: $24,000,000

Indiana: $11,000,000

Iowa: $9,600,000

Kansas: $13,700,000

Kentucky: $14,800,000

Louisiana: $16,200,000

Maryland: $23,400,000

Massachusetts: $32,650,000

Michigan: $22,900,000

Minnesota: $21,350,000

Mississippi: $18,950,000

Montana: $19,850,000

Nebraska: $17,450,000

Nevada: $30,300,000

New Hampshire: $26,100,000

New Jersey: $37,000,000

New York: $34,650,000

North Carolina: $29,950,000

Ohio: $28,050,000

Oklahoma: $33,150,000

Oregon: $35,550,000

Pennsylvania: $46,600,000

Rhode Island: $27,450,000

South Dakota: $15,350,000

Tennessee: $23,500,000

Texas: $42,150,000

Utah: $31,000,000

Vermont: $31,200,000

Virginia: $36,050,000

Washington: $47,600,000

West Virginia: $21,700,000

Wisconsin: $25,200,000

Wyoming: $13,500,000

How to calculate R&D tax credit

Once you determine whether or not your company earns enough revenue to qualify for the R&D tax credit, the next step is figuring out just how much money your team should spend before claiming the deduction. To find this value, divide the total cost of qualified R&D expenses by the number of hours worked on the project.

As an example, let's say you hired two developers to write software for your company. You estimated that they were responsible for 8 hours of work each day. Assuming a 40 hour week, your company would have spent approximately $2,000 on qualifying R&D expenses. Now, simply multiply the result by 0.2 (the percentage of your gross profit earned by the government). Your final calculation is $400. That's the amount of money you would owe the IRS after taking the 20 percent off.

You can download a Microsoft Excel template here so you can keep track of your R&D expenses and earnings over time.

And finally, if you're unsure about whether or not you qualify for the R&D tax credit, contact us today -- we can provide expert advice tailored specifically for your needs.

Qualifying Software

To qualify for the R&D tax credit, qualifying software must meet two criteria. First, it must be developed with a “direct use in business” as defined by Section 174(c)(3). Second, the product must be produced within three years after its original purchase date.

When determining whether software qualifies for this credit, you should consider what kind of software you are developing. For example, if you have purchased software development tools like Visual Studio, then the software would likely not qualify because they are used primarily for personal use rather than commercial purposes. However, if your company is purchasing software such as Microsoft Office 365 or Adobe Creative Cloud, these products can still qualify under the definition of direct use.

Direct Use in Business - As mentioned above, the first criterion for qualification is that the software must be used directly in business. According to IRS Publication 946, any item that meets the following requirements will qualify for the R&D tax credit:

It has been substantially developed at least 40 hours per week over a period of three consecutive calendar months.

For all other items, there must be proof that the total number of hours exceeds 50 percent of the average weekly work effort required to develop similar types of property during the same time period. If no suitable records exist, there must be evidence provided by independent third parties verifying the amount of labor expended.

As long as the software is being used in business, even if only partially, the second requirement of production within three years of initial purchase will also be met. In addition, certain software packages fall outside the scope of this program but do still provide some benefits for businesses who purchase them. These include:

Microsoft Azure cloud computing service – Qualified costs associated with running applications in the cloud.

The US Congress has passed a law that will allow small businesses to deduct from their taxes all eligible R&D expenses they incur in 2022 (and possibly also in future years). This is great news for those who are interested in saving money on their taxes by claiming R&D expense deductions through software development.

But if you're wondering whether or not your company qualifies for this new tax deduction, here's what you need to know about it.

First off, let’s talk about exactly what an R&D tax credit is. The purpose behind the R&D tax credit was to incentivize businesses to invest in innovative technologies. But there were two major problems with the original legislation. First, some industries like oil and gas didn't have enough funds to make investments in tech at all. Second, many other industries couldn't get any sort of tax break because the IRS had too strict rules regarding which types of businesses could claim certain amounts as deductible expenses.

To fix these issues, President Donald Trump signed into law the Tax Cuts and Jobs Act of 2017, which included a provision allowing the general public to deduct 50 percent of qualifying R&D expenses from its federal income taxes. This means that anyone can now write off half of all R&D expenditures made during 2022. A separate section allows taxpayers to write off 100 percent of R&D expenses incurred after December 31st, 2021, and before January 1st, 2023. However, the percentage of R&D expenses that gets written off depends heavily upon the taxpayer’s marginal rate. For example, someone making $50,000 per year would only receive 50 percent of their R&D expenses deducted from their taxes, whereas someone earning over $200,000 annually would get full coverage of their R&D expenses.

If you think that sounds really complicated, don’t worry - there are several ways that you can determine if your business qualifies for the R&D tax credit. We'll discuss each one below.

Does internal use software qualify for R&D credit?

Internal use software refers to products used internally within a company. If you develop applications for your own employees, such as payroll systems, customer relationship management platforms, etc., then yes, you do qualify for the R&D tax credit. In fact, you don’t even have to spend anything out-of-pocket yourself for your employees to take advantage of the R&D tax credit. You just have to provide them access to whatever product you choose.

You should note that while the Internal Revenue Service recognizes internal use software, it doesn't consider websites to be part of the definition of "internal use." So, if you build a custom web app for your customers using JavaScript, HTML5, CSS3, PHP, MySQL, Apache, or similar programming languages, you might want to reconsider calling it internal use software.

Is software development considered R&D?

As we mentioned above, the government considers software development to be “research” under the R&D tax credit. That being said, there isn’t a hard rule saying that every project must involve actual testing and experimentation. Instead, the IRS uses four factors to decide whether something counts as R&D. These include:

1) Is the activity conducted primarily for the benefit of the taxpayer?

2) Does the activity require specialized knowledge?

3) Are results obtained important to the taxpayer?

4) Did the taxpayer expend significant effort?

Even though software developers generally meet most of these criteria, the IRS still requires proof that the work done meets specific standards. They want evidence showing that the developer did extensive planning and analysis prior to beginning work on the project, or that tests weren’t performed until after the final version of the program was complete. And since software projects often span multiple months, the IRS wants documentation proving that the developer stayed focused throughout the entire process.

What does not qualify for the R&D credit?

There are plenty of things that don’t count as R&D, including advertising campaigns, promotions, events, conferences, and travel related to sales and marketing. These kinds of expenses aren’t meant to create valuable innovations but rather increase revenue. Also excluded from the definition of R&D are charitable donations, donations to political parties, lobbying efforts, and payments made to nonprofit organizations working towards better health care services.

Finally, the IRS excludes any items that don’t cost money. It includes everything from food purchases to car repairs, so long as the money spent wasn’t specifically allocated toward developing the item in question.

What activities qualify for R&D credit?

In order to be eligible for the R&D tax credit, you must prove that the following three elements are true:

1) Your spending needs to be directly connected to the creation of a new product or service.

2) There needs to be a clear connection between the expenditure and the product or service itself.

3) You cannot simply claim the expenditure as a loss.

For instance, if you purchase a piece of equipment that improves productivity, you can definitely claim the value of the machine against your gross profit when calculating taxable income. But if you buy the same machine twice, once to improve productivity and another time to reduce inventory, you won’t be allowed to offset either amount against your profits. Similarly, if you pay contractors to perform tasks unrelated to improving a product or service, you won’t be able to take the resulting savings as a tax deduction.

The best way to find out if your business qualifies for the R&D tax credit is to consult the relevant regulations issued by the Treasury Department. To learn more about how to calculate it, check out our guide to calculating R&D tax credits.

What is the definition of \"qualified\"?

To claim an R&D deduction you must meet two requirements:

You cannot take any other type of business tax break.

Your total deductible costs must exceed $10 million USD for 2022 or $50 million per year starting with 2023.

If your company meets both conditions above then it can claim its R&D expenses as a deduction against its taxable income. The amount claimed would depend on how much your company spent on qualifying R&D activities during the period covered under this tax break.

Qualifying Research & Development Activities

For example, if your company had 5 employees working full-time on qualifying R&D projects during the relevant time frame, you could claim 25 percent of each person’s salary as a deduction. You can only claim R&D credits for qualified activities which involve new products, processes, or services. So, don't count work done on existing systems or programs towards this calculation.

It’s important to note that qualifying R&D activity does not have to result in tangible goods being produced. It just needs to relate to developing new things that are either intended to be sold or might eventually lead to sales.

So, if your company develops software for internal use but expects to sell it at some point down the road, that qualifies as “research” even though there isn’t anything physical that was created. Similarly, writing articles about your company's technology doesn’t constitute qualifying R&D unless it leads to actual production of something new.

In order to find out whether your company’s work fits into one of these categories, check out the IRS website where you can download forms related to eligibility for R&