It’s Official: Software Development Included in Tax Definition of R&D

At a glance

• The bad news: Changes to the tax code recently went into effect requiring all R&D costs to be capitalized and amortized, including software development.
• The good news: These changes provide more clarity regarding the eligibility to classify all internally-developed software as R&D costs, further strengthening the position to include certain software development costs in the R&D Tax Credit.
• Time to act: Companies need to begin preparing for the tax ramifications of these changes now, including reassessing their eligibility for the R&D Tax Credit, your best tool to help offset the impact.

Schedule a consultation with our R&D Tax Credit team today.

The full story:

Research and development (R&D) expenditures are no longer immediately deductible after a provision of the Tax Cuts and Jobs Act (TCJA) went into effect for tax years beginning on or after January 1, 2022. The changes altered Section 174 to require companies to capitalize and amortize R&D costs over several years – 5 for domestic activities or 15 for foreign activities. While companies have had years to prepare for this change, many have taken a “wait and see” approach. Halfway through the 2022 tax year, now is the time to plan for how these changes will impact your cash flow.

Aprio recently hosted a webinar and published an article exploring the ramifications of the change, joining the chorus of other tax professionals urging companies to take heed of the expansive impacts of the change. If we’re beginning to sound repetitive, it’s because we know the impacts will be significant and costly.

Lessen the blow with an R&D Credit

Given the expansive definition of R&D for U.S. tax purposes, many employees in your company may be performing R&D activities without even realizing it.  This change could dramatically impact your company’s bottom line. To help offset the impact of capitalizing and amortizing these costs that were previously fully deductible as incurred, companies should reassess their eligibility to claim the R&D Tax Credit, a separate tax incentive that reduces tax liability with a credit for certain qualified R&D expenditures.

However, claiming the R&D credit isn’t entirely risk-free. Companies can only claim the R&D credit for activities that satisfy four unique criteria established by the tax code, known as the four-part test. It’s worth noting that some categories of development activities must meet additional criteria to qualify (such as software used in back-office functions developed solely for internal use) but the four-part test defines the general eligibility for claiming the R&D credit. To meet the four-part test, research activities must:

1. Satisfy the Section 174 test, meaning activities must be intended to overcome a technical uncertainty (e.g. a technical challenge);
2. Aim to discover technological information using principles that are technological in nature;
3. Constitute a process of experimentation intending to eliminate technological uncertainty, and
4. Be performed for a permitted purpose, such as improving the function, performance, reliability, or quality of a business component.  

Historically, due to a lack of clear guidance regarding certain software development activities, it was not uncommon for the IRS to challenge the inclusion of related costs in an R&D credit. In these scenarios, the IRS often argued that software development did not satisfy the first (uncertainty) or third (process of experimentation) components of the four-part test. Subsequently, this position of the IRS dissuaded many companies from pursuing an R&D credit for software development.

Seize new opportunities in software development

With the latest changes to Section 174 rules, Congress explicitly included software development in its definition of R&D costs. Yes, this means all software development costs are subject to the new 174 requirements. However, it also clearly defines all software development as a 174-eligible activity, which is indicative of congressional intent to consider software development activities when determining R&D Tax Credit eligibility.

While there may not be much good news associated with the Section 174 changes, this is potentially a small win for companies that employ or contract with software developers – especially those who have been hesitant to claim the R&D credit in the past. Companies that have not historically claimed the R&D credit for software development activities should re-evaluate the opportunities to claim the credit on these types of expenditures prospectively as well as for open tax years.

If your company is considering amending to claim the R&D credit, you should also take note of other recent changes requiring additional documentation to support these refund claims. You can read more about these changes in this previous article, and be on the lookout for an upcoming article exploring additional ramifications of these new requirements.

The bottom line

For all companies performing R&D through the development and improvement of products and/or processes (including software), the new rules will inevitably trigger significant changes to your tax burden and require thorough analysis and planning. If these changes seem overwhelming and complicated, you’re not alone – Aprio is here to help.

Aprio’s team of advisors can provide the multidisciplinary expertise you need to achieve tax cash savings while remaining in compliance with the new laws. Contact Carli Huband, Specialty Tax Leader, or Dave Hanson, Executive Director of R&D Tax Credit Services, to start planning your strategy.

Related resources

• Brace for Impact: Changes to R&D Deductions Begin This Year
• New Guidance from the IRS Makes Claiming R&D Credits More Complex
• Video: How R&D Expenditures Can Impact your 2022 Tax Plan and Beyond