Have you attempted to improve your revenues and margins by adding to and improving your product list? Do you continually fight competitive pricing pressures by working to improve your efficiency and reduce costs? If you answered yes, the federal government wants to help you finance these activities through the Research & Development Credit, a direct reduction of the tax liability on your corporate income tax return. In California and many other states, R&D credits are also available at the state level.

Although the R&D credit has been law for a number of years, there remain for software companies a number of definitional complexities that could make it more challenging for them to fully claim the credits they are entitled to. For software companies, the secret to working through the complexities lies in understanding what's deductible and subject to the credit-then carefully classifying and documenting these expenses.

What activities qualify for the R & D credit for software development companies?

Expenses related to activities companies do every day to stay competitive can generate credits. This includes creating new products, improving existing products, and changing your products to meet specific customer needs. The Internal Revenue Service (IRS) recognizes that many of these changes are evolutionary rather than revolutionary in nature. Therefore, it is not necessary for the improvements to be significant enough to be patentable. The only requirements are that the improvements involve:

• Technology - a hard science such as computer science, engineering, chemistry, or physics
• Some uncertainty at a project's outset
• Development that uses a process of trial and error or experimentation

Additionally, according to the Internal Revenue Code (IRC, Section 174), other expenditures for activities intended to discover information that would eliminate uncertainty concerning the capability, method or design of a product qualify as research and development expenditures even if the product is intended to be used internally by the taxpayer for management functions or the expenditures relate to non-functional aspects of the product (i.e., style, taste, cosmetic, or seasonal design).

In the case of software development companies, the IRS has maintained that activities related to the development of computer software closely resemble research and development under IRC Section 174. These rules apply to the software developed whether or not the software is patented, and regardless of whether the software will be used by the developer or held for sale or lease to others. (The cost of purchased software is not eligible for this current expense treatment and must be amortized.)

There are several additional criteria that must be met under the IRC to be eligible for the R&D tax credit:

1) The expenditures are paid or incurred in carrying on a trade or business (that is, the taxpayer must generally use the results of the research in its trade or business).

2) The research is undertaken for the purpose of discovering information that is technological in nature.

3) The application of the research must be intended to be useful in the development of a new or improved business component of the taxpayer. The term business component means any product, process computer software, technique, formula or invention which is to be held for sale, lease or license or used by the taxpayer in a trade or business of the taxpayer. Thus, software activities will generally be eligible for the credit if they meet the same tests applicable to other product or process development activities as mentioned above. However, with respect to the development of internal-use software, restrictions apply.

4) Substantially all activities constitute elements of a process of experimentation for a qualifying purpose. (Qualified research must involve evaluating more than one alternative designed to achieve a certain result, when the means to that certain result is uncertain at the onset of the research. Experimentation includes the formal scientific process of developing, testing, analyzing and refining and/or discarding hypotheses.)

What kinds of research expenditures qualify for the R&D credit?

IRC Section 41 (b)(1) defines qualified research expenses as amounts paid or incurred by the taxpayer during the taxable year in carrying on a trade or business relating to in-house research and contract research. In-house research consists of all amounts paid or incurred for wages, supplies and amounts paid or incurred to another person for the right to use computers in the conduct of qualified research.

Wages. Wages includes amounts paid or incurred to an employee in the performance of qualified research activities. However, amounts paid that do not require Federal income tax withholding do not qualify for the credit.

With regard to wages, a special rule applies if "substantially all" of the employee's hours are worked in qualifying services. If the employee spends at least 80% of his/her time performing qualified services during a given year, then all of the employee's wages for the year will qualify for the credit computation.

"Qualifying services" include the following:

1) Services engaged in qualifying research.

2) Direct supervision of qualified research activities (i.e., immediate supervision by a person of the research activities even though the supervisor does not actually perform any of the experiments).

3) Direct support of qualified research activities. Direct support includes activities that directly support the persons engaged in the research activities (i.e., assistants, secretaries who type reports, other aides who compile statistical data) or other direct support positions to the qualified research (i.e., machinists building the prototype, workers who clean research equipment, etc.). Direct support does not, however, include general and administrative costs.

Supplies. A second eligible cost includes supplies. Supplies are defined as any tangible personal property other than land or improvements, or property subject to the allowance for depreciation, that are directly used in the conduct of qualified research. Thus, the acquisition of depreciable property and any depreciation allowances are not eligible for the credit. Please keep in mind that only actual supplies used in the qualifying research are eligible. A taxpayer can allocate supplies between qualifying and non-qualifying activities, provided the allocation is reasonable.

Contract research. Contract research costs are also eligible costs for the credit. Generally, 65% of any amount paid or incurred by the taxpayer to another person to perform qualified research for the taxpayer qualifies for the credit. This excludes employees of the taxpayer. However, if the payments are made to a Sec. 501(c)(3) tax-exempt organization, and this organization's primarily purpose is to conduct research, the amount is increased to 75%.

With regard to contract research payments, there are certain requirements that need to be met. These requirements are:

1) The contract (preferably written) was entered into prior to the performance of the contract services.

2) The agreement states that the research must be conducted on behalf of the taxpayer (taxpayer has a right to the research results, but exclusive rights are not required).

3) The agreement states that the taxpayer bears the expense of the research even though the research may prove unsuccessful. In other words, contingent payment agreements upon only successful research activities will not qualify.

What are the Documentation Requirements?

In order to be eligible for the deduction and credit for software development activities, your company must be able to support the calculation of which costs are deductible, including a breakdown of the costs incurred by category as discussed above.

In addition, in the event that the credit is challenged by the taxing authorities, you should be able to provide documentation demonstrating your company's:

• understanding of the credit;
• determination of which activities qualify for the credit;
• determination of which costs qualify for the credit;
• calculation of the credit for each tax year that the credit is taken.

It is recommended that, where applicable, your company also document the following items:

• credit study surveys (questionnaires)
• company organization charts
• accounting, financial, policy and other manuals that describe the company's research and development activities and its understanding of the research credit
• patent or copyright applications and related documentation
• project authorizations, budgets and work orders
• internal authorization policies for projects
• original project proposals
• project descriptions, justifications, budgets, risk evaluations, and schedules
• interviews with persons who performed the research activities at various levels
• breakdown of accounts and costs that make up the qualified costs
• ongoing project reports
• problem/issue reports
• actual to budget reports
• status reports
• experimental research data
• other materials explaining the company's research activities
• marketing documents
• press releases
• product brochures
• contract research documents for outside contractors or consultants
• licensing agreements

Deducting the research credit for R&D activities related to software development costs is an area that is heavily scrutinized by the IRS. In light of these requirements, some of which leave room for interpretation on a case-by-case basis, the challenge for any software company it to review its software development activities and properly document and classify these costs in accordance with the current tax law and legislative history. But despite these challenges, you should consult a qualified tax advisor and thoroughly review the federal and state-level R&D opportunities that could have enormous long-term benefits for your company's bottom line.

This article is intended to provide general information for the benefit of members of the Software Council. It should not be construed as tax advice for specific situations.

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