The R&D Tax Aspects of Software Development

By Charles R Goulding, Charles G Goulding, and Rachelle Arum

        Software development is a strong candidate for the federal research and development tax credits. Many aspects of software development are credit eligible; these include preliminary scoping, prototyping, core build, testing, evolution, as well as integration with various platforms and operating systems. In addition, many companies are adding software-based components to their traditional product offerings. As more companies develop such features, so too do more companies have R&D tax credit eligibility.

The Research and Development Tax Credit

        Enacted in 1981, the federal Research and Development (R&D) Tax Credit allows a credit of up to 13 percent of eligible spending for new and improved products and processes. Qualified research must meet the following four criteria:

• New or improved products, processes, or software
• Technological in nature
• Elimination of uncertainty
• Process of experimentation

        Eligible costs include employee wages, cost of supplies, cost of testing, contract research expenses, and costs associated with developing a patent. On January 2, 2013, President Obama signed the bill extending the R&D Tax Credit for 2012 and 2013 tax years.

Software Development: Programmed for Tax Savings

        To meet fast-paced needs, software development is increasingly headed toward an "agile" model in which software quickly comes to market and is then subject to continuous maintenance and improvement. The agile model blurs the boundaries of traditional software development stages and makes every stage a potential source of R&D expense. Below are common development stages and their R&D tax credit relevancy:

• Preliminary Analysis: The phase includes initial scoping and defining of software requirements and feasibility. A great deal of technical uncertainty must be addressed by means of experimentation, examination of alternatives, and prototyping. Often, specific documents result from these activities, including a Systems Boundary Document, a Project Management Plan, and a Functional Requirements Document, all of which provide excellent R&D credit documentation.
  
  
• Design and Development: With functionality requirements defined, the question becomes how to actually design the software. Whereas rote design elements and coding are not credit eligible, elements of the build which are new to the developer have credit eligibility. These might include a specific feature or needed integration with platforms and operating systems.
  
  
• Testing: Testing determines how well the design meets the requirements outlined in the preliminary analysis. Errors are debugged, and the design is reconfigured or enhanced. Text Analysis Reports substantiate the R&D which occurs at this phase. By contrast, routine quality control testing of software would not be credit eligible.
  
  
• Evolution: This phase is often the longest part of the development cycle and contains meaningful R&D credit elements. Particularly for agile development, beta versions of the software are subject to constant fixes, enhancements, iterations, and evolution.

Cloudy with a Chance of R&D Credits

        The cloud is another way by which programming is becoming more agile; development stages occur in parallel with one another rather than serially. The cloud facilitates this by providing excess server capacity and a universe of development tools, many of them open source, which the developer can access at will .

        In essence, the cloud is a virtual R&D playground, supplying the developer with a larger set of tools and capabilities than he would otherwise have access too. This universe of possibility allows developers to focus on making the core product offering as agile, robust, and innovative as possible.

        The cloud is one of many ways in which the "connected world" has resulted in a change in paradigm. Rather than occur in silos, R&D is now a collaborative effort, supported by a wide array of coalitions, start-ups, private/academic partnerships, open-source development and even competitions where winning codes, algorithms and designs receive recognition and funding.

        Consumers make up part of the connected world, too. Data from web and Smartphone usage and from sensors, for example, provides an ever-expanding universe of digital information. Many firms now employ directors of analytics to make sophisticated use of Big Data to better define corporate strategies and understand consumer preferences. The big data-driven insights from these analytics often result in product offerings, algorithms, apps, and other deliverables that are credit eligible.

Every Company is a Software Company

        More and more, companies outside the traditional high-tech industry are involved in software development. A recent Forbes article "Now Every Company is a Software Company" shows how even some of America's most venerable companies are turning to software to enhance their product lines and find new growth.

        Ford Motor Company, for example, is equipping its latest vehicles with features like wifi receivers which turn its cars into mobile hotspots, software to help its vehicles maximize energy efficiency, and sensors to assist with parallel parking. The old-fashioned, utilitarian concept of the car as way of getting from point A to point B no longer captures the way Ford views cars or the needs of the people who drive them.

        Some companies now engaged in major software initiatives have no historic foundation in technology whatsoever. McKinsey, the consulting firm, began developing software applications to enhance their consulting and report capabilities. Eventually, McKinsey realized these applications held value to outside firms and began selling their software programs, which now total twenty-one in number. This division within McKinsey has become large enough to constitute a sizable tech start-up by Silicon Valley standards. As a result of software, even an industry like consulting which historically had little R&D credit eligibility is now generating appropriate expenses for the credit.

Start-Up Software Development Companies

        Early stage start-ups are often highly R&D-intensive. Moreover, the credit is in fact a credit for increasing research activities; at no time in a company's history are its R&D expenses increasing at a faster rate than as a start-up.

        Lack of immediate tax capacity is not a reason for a start up to ignore the credit: R&D tax credits can be carried forward as many as twenty years. Establishing R&D accounting practices early pays large dividends down the road. Many start-ups see acquisition as their end-game, wherein sound accounting, including R&D credit readiness, can be a meaningful part of asset valuation.

Conclusion

        More companies are following the successful IBM model of using data to provide solutions to a wide array of problems. Even IBM has indicated that their goal is to develop more software related to social media, cloud computing and mobile phones . Both software companies and companies now delving into software-based features and solutions should examine their R&D tax credit eligibility.

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