How to Qualify Software Activities for the R&D Tax Credit

(R&D Tax Credit Digital Transformation for Retailers Webinar, Dec 2020)

When companies in the retail industry are asked about their digital transformation initiatives, they often give very different answers because digital transformation can be applied to just about every aspect of retail. Some retailers are focusing on the supply chain, others on inventory or warehousing, many are figuring out how to leverage the enormous amount of data they have, and everybody is at least taking a look at customer-facing areas to identify how technology can help improve performance.

Some companies have said they are hesitant to pursue a claim for the federal research and development tax credit because software is often the business component, and it has the reputation of being more difficult to qualify for the tax credit with confidence. If a business understands the spirit of the law and is aware of all the resources available to it, it can confidently qualify many digital transformation software activities for the R&D tax credit.

A quick note on software as the business component. Digital transformation projects ultimately change business processes. But you will never get companies to adopt and learn the new processes until the new workflow is supported and reinforced, usually through software. This leads some companies to regard the software as the solution when it’s really a tool to implement changes to their business processes. The IRS is not going to let companies claim a tax credit for redesigning their business processes, so software is usually the focus.

In TCC’s experience, digital transformation projects tend to either have many qualifying activities or very few. This makes it easier because a quick high-level assessment can be done to determine whether a project is worth a more detailed look.

The IRS has created a 17-page document that’s dedicated to helping examiners qualify software projects and activities. If you have trouble falling asleep tonight, grab a copy of  “Audit Guidelines on the Application of the Process of Experimentation for all Software” and give it a read. As you read, you will notice that the IRS keeps repeating the same phrases over and over again throughout the entire document:

“… software activities that are directed at resolving software development uncertainties through a process of experimentation by identifying and conducting a process designed to evaluate alternatives which fundamentally relies on the principles of computer science.”

This is the spirit of the law. It’s designed to reward companies that invest in research and development to create a software business component. The project uses computer science principles to figure out the right solution by experimenting with alternatives.

The rest of the document provides examples of activities that probably don’t qualify (high-risk), sometimes don’t qualify (medium-risk), and usually qualify (low-risk).

Project Litmus Test

Here’s the litmus test for whether the project will qualify for the tax credit:

  1. Is the company buying prepackaged or off-the-shelf software and configuring it for its needs?
  2. Is the company creating a customized software tool because there’s nothing it can buy that will do exactly what it needs?

Very Few Qualified Activities

If a business answers “Yes” to #1 and “No” to #2, it’s very unlikely to have many qualifying activities. Hopefully, the company that developed the software package that the business bought claimed a huge tax credit when they built the system and eliminated all the uncertainty. Here are a few more specific examples of what doesn’t qualify for the tax credit:

  1. Performing a study to select the best vendor solution,
  2. Detecting flaws and bugs in the vendor’s e-commerce system or how it was implemented,
  3. Upgrading to new versions of the software or installing software patches,
  4. Modifying other business components to comply with the new e-commerce system,
  5. Creating vendor product extensions where there are well-defined Application Programming Interfaces (APIs) that extensions must comply with and that do not modify the vendor application itself,
  6. Configuring data field labels, lookup tables, and formulas,
  7. Importing data from a legacy system to initially populate the e-commerce system,
  8. Creating software that validates or cleans data fields or makes them consistent across databases and applications,
  9. Configuring the screens that customers use to shop and check out, or
  10. Creating the content for emails and other notifications sent to customers during the ordering and delivery process.

Many Qualified Activities

If a business answers “No” to #1 and “Yes” to #2, it’s likely to have many more qualifying activities because it’s likely beginning a process that’s chock full of uncertainty. As the document mentions, a company should use a formal software development or software lifecycle process to categorize the software activities in phases and then qualify them by phase. The company is likely to have qualifying activities in just about every phase except for the post-production phase.

Activities that often qualify include:

  1. Designing the software and creating the system architecture,
  2. Creating new database management techniques and structures,
  3. Developing new algorithms,
  4. Coding and compiling the system, and
  5. Testing the software.

All qualifying activities end immediately when the first version of the software is released. Very few activities will qualify after that point, including work to debug and fix errors in the software.

By reading the IRS document several times and having it handy when looking at software development activities, and using the information contained in this article, companies should be able to qualify software development activities – and claim that credit – with confidence.

More Tax Credit Insights

Free assessment

Talk To a Tax Credit Expert Today

Connect with a partner relationship manager to explore our turn-key solutions and integrations.

Get a free assessment