Software Startups Shouldn’t Gamble When Claiming the R&D Tax Credit

You can’t cut your risk of an audit to zero, but here are the most important ways that you can avoid raising red flags — or getting stung if the taxman does decide to take a closer look at your books.
Headshot of author Lloyed Lobo
Lloyed Lobo
Expert Contributor
May 11, 2021
Updated: May 12, 2021
Headshot of author Lloyed Lobo
Lloyed Lobo
Expert Contributor
May 11, 2021
Updated: May 12, 2021

The COVID crisis left countless businesses looking for new sources of capital, leading many companies to turn their attention to R&D credits for the first time. As difficult as the past year has been, that’s one silver lining.

While not every new process or way of problem solving qualifies for an R&D credit, businesses that have pivoted during the pandemic may well qualify for these important tax incentives, and nobody wants to leave money on the table. Companies should claim all the innovation incentives for which they’re eligible.

Still, the R&D tax credit system can be complicated, and in the scramble to raise funds some businesses cut corners, got bad advice or simply made poor decisions. Now the IRS is starting to pay more attention — including adding R&D credit fraud to their “dirty dozen” list of tax scams — and many businesses that made mistakes or poor choices when claiming R&D credits could soon face an unpleasant comeuppance.

With recently updated R&D credit audit guidelines in place for software development, businesses face stringent tests of their eligibility on top of existing rules that require taxpayers to maintain contemporaneous technical and financial documentation for any R&D work for which they want to claim a credit. Companies that prepare claims without doing the proper technical and financial due diligence could face big headaches down the line when dealing with the IRS.

Gambling that you will avoid an audit is always a bad idea, and with the federal government now getting serious about enforcement, this is a particularly bad time to try rolling the dice. You can’t cut your risk of an audit to zero, but here are the most important ways that you can avoid raising red flags — or getting stung if the taxman does decide to take a closer look at your books.

 

Avoid Exaggerated Claims

It might sound trivial, but simply being precise and getting your sums right can help to ensure that auditors don’t decide to take a closer look. One example: If you’re claiming engineers’ time was 100 percent dedicated to R&D, refer back to the audit guideline to see what portion of their work truly qualifies.

Getting these details right is easier said than done, so check your work, then check it again — or consider using automated software to track and gather your information proactively throughout the year, figure out what qualifies and do the math for you so that you’re not playing the guessing game after the end of your tax year. The IRS’s “dirty dozen” list of tax scams warns that taxpayers should “avoid improperly claiming various business tax credits, a common scam used by unscrupulous tax preparers.” That includes misuse of the research credit that often involve making inflated claims or failing to properly substantiate qualified research activities.

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Know What Counts as Research

Make sure everything you claim for R&D credit passes the IRS’s four-part test and truly counts as “qualified research.” That means that “substantially all of the activities of the research” must have been used to develop new or improve existing functionality, performance, reliability, or quality of a business component — i.e. product, process, technique, invention, formula, or computer software that you intend to hold for sale, lease, license or actual use in your trade or business.

You must also undergo a systematic, science-based “process of experimentation” to resolve an area of technological uncertainty. You can’t just pull an idea out of the air and call it innovation; you need a rigorous research program to justify the credit you’re claiming.

At the same time, it’s important to know what doesn’t count as research. Studies, surveys, overseas research, grant-funded R&D, reverse engineering of other companies’ tech, and post-production research are all excluded from credits. The aim of the R&D credit is to support U.S. innovation that delivers tangible benefits — so anything that includes work done outside the country, or that doesn’t clearly and directly lead to a genuinely new or improved product or process, is explicitly excluded from the credit.

 

Understand Uncertainty and the ‘Process of Experimentation’

The experimental process underpinning R&D is supposed to include some element of risk and uncertainty. According to the IRS, “uncertainty exists if the information available to the taxpayer does not establish the capability of development or improvement, method of development for developing or improving the product or [its] appropriate design.”

The IRS also warns that “merely demonstrating that uncertainty has been eliminated ... is insufficient.” That means you need to engage in a process of experimentation. If you are easily able to find the solutions to overcome uncertainty without a process of experimentation, then you’re simply building something — but that doesn’t mean it qualifies for the R&D credit.

For software developers, this is a slightly murky area: While the risky creative work of developing new software certainly qualifies, the more mundane uncertainties that come with configuring a bit of software to work in a given context wouldn’t count as a claimable R&D activity. Neither would the uncertainties inherent in running a business. You might not know whether customers will respond favorably to your product, or whether staff can be trained to use it effectively, but those risks alone aren’t enough to qualify for an R&D credit. As the Code of Federal Regulations lays out in section 1.41-4(a)(5):

“A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science and involves the identification of uncertainty, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology).”

 

Take Risks Mindfully

The IRS breaks down software R&D according to the risk of it being rejected as not constituting qualified research activities, so it’s important to understand how much of a risk you’re taking when you claim a particular activity as R&D for tax purposes. Some examples:

  • Modifying an existing software business component to make use of new or existing standards or devices.
     
  • Maintaining or debugging existing products.
     
  • Developing software substantially similar to the capabilities already in existence at other companies.
     
  • Extending products from other vendors.
     
  • Designing graphical user interfaces.
     
  • Bundling software together.
     
  • Upgrading or patching existing software.
     
  • Creating hardware device drivers.

These are all “high-risk” activities that usually fail to pass muster. Functional enhancements to existing software applications and products, changing from a product based on one technology to a product based on a different or newer technology — e.g., switching from a hierarchical database technology to a relational database technology — are “moderate-risk” activities that often fail to constitute qualified research. Hiring a team of computer scientists to develop specialized technologies, such as image processing, artificial intelligence or speech recognition, on the other hand, would be a “low-risk” activity that would almost always win approval.

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Document Everything

The key to surviving an audit is keeping good records — and ensuring that every cent you claim can be properly accounted for. The idea is to ensure you have an R&D study grounded in robust, contemporaneous evidence explaining the work that was done and the results it yielded. This requires accurate records prepared by someone who knows what they’re doing. The IRS routinely rejects studies that are simply generic boilerplate or that fail to properly articulate and document the research that was completed. You’ll need to think about this as you’re doing the research, not just when it’s time to claim a credit. Going back and trying to fill in the blanks retroactively is a recipe for disaster.

It’s clear that the COVID pandemic has thrown the tax system into turmoil. Just look at the IRS’s failure to process submitted returns or its decision to extend individual tax returns for a month. Amid the chaos, it might seem like a shoddy R&D tax credit claim will simply get swept under the rug. The reality, though, is that, while the IRS is currently floundering a bit, the paperwork you file when you claim an R&D tax credit will remain on file for years to come. When the dust settles, many companies that incorrectly filed R&D credit claims will wind up exposed.

This doesn’t mean you should forgo the tax credits to which you’re entitled. With many small businesses able to claim up to $250,000 in research incentives, it’s worth doing your homework and making sure that you aren’t missing out on a benefit that could help your company to keep on growing during these difficult times. But don’t take shortcuts along the way, and don’t assume you can navigate the complexities of the R&D incentive system without expert assistance.

The bottom line: The R&D tax credit system is a massive helping hand for American businesses, but it can also be risky. If you’re new to R&D tax credits, make sure you understand your obligations — and if you’re an experienced R&D credit claimant who’s managed to avoid getting audited so far, don’t count on staying lucky. When it comes to innovation incentives, it’s far better to put the right processes in place now and to be sure you only claim credits to which you’re truly entitled.

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