Balancing §174 R&E Software Development Tax Obligations with R&D Tax Credits

Which Software Development Costs are governed by the new §174 R&E Amortization guidelines?

Amidst the intriguing realm of §174 Expenditures, a captivating array of potential costs awaits exploration:

• Enigmatic salaries and wages encompass both employer costs and the magic of human capital.
• Licenses for ethereal software unlock the gates to digital wonders.
• The ephemeral embrace of equipment rental costs empowers progress with temporary tools.
• The alluring aura of occupancy costs, where office rent and research facilities intertwine.
• Travel expenditures are a gateway to distant realms of R&E pursuits.
• The mesmerizing dance of heat, light, telephone bills, and similar overhead utility costs illuminates the path to innovation.
• The fleeting touch of depreciation marks the passage of time on tangible assets.
• The hidden secrets of dues and publication expenses, illuminate the path to R&E purposes.
• Attorney fees and filing fees are guardian angels of innovation, standing watch over patient's dreams.

Recent Revisions in §174 Amortization for Software Development

Recent changes to §174, as per IRS guidance under Rev. Proc. 2023-11, impact software development in the following ways:

• Taxpayers with software development costs must amortize them over 5 years for domestic research costs and 15 years for foreign research costs.
• The costs can no longer be fully deducted in the year they are paid or incurred.
• Historically, §174 Research & Experimental (R&E) expenditures allowed for the deduction or amortization of direct and indirect costs for R&E activities.
• However, the Tax Cuts and Jobs Act (TCJA) of 2017 altered the treatment of R&E expenditures, now requiring amortization.

How Does This Influence Taxpayers Pursuing the R&D Tax Credit for Software Development?

Regardless of taxpayer's claims for the R&D tax credit, adherence to §174 mandates the amortization of costs.

Though 174 and §41 (R&D tax credit) stand as separate tax sections with distinct rules, they share similar definitions of R&D. Consequently, software development costs amortized under §174 might also qualify for R&D tax credits under §41, offering a means to counterbalance the tax liability arising from §174 amortization.

What Separates §174 R&E Expenditures from §41 R&D Tax Credit Expenses in Software Development?

The allure of R&D tax credits lies in their claim ability for direct research expenses, which encompass wages, contractor expenses, supplies, and more. Meanwhile, §174 stretches its embrace, encompassing these direct expenses and venturing into the realm of certain indirect research costs, including facility expenses, which are excluded from the R&D credit calculation.

While a vast majority of R&D tax credit expenses readily align with §174 expenditures, not all §174 outlays attain the qualifying threshold required for claiming the R&D tax credit. Thus, many companies will find themselves with §174 expenditures, even if they opt not to pursue the R&D tax credit's enchanting rewards.

Acquiring R&D Tax Credits for Software Development

The following are examples of qualified research activities for software development companies to claim under the R&D tax credit:

• Design and development of new software components
• Design and development of new or improved software applications
• Internal Use Software development
• Virtual reality or game development
• Developing data mining techniques including big data analysis and processing
• Development of firmware
• Development of POS systems
• Integrating hardware and software components
• Development of document management systems
• Development of education-based software
• Design and development of CRMs
• Design and development of compliance systems
• Healthcare system and application development
• Development of financial and accounting software
• Developing simulators
• Development of data center tools
• Development of monitoring systems
• Development and integration of databases
• Designing and experimenting with computer hardware
• Reducing system latency
• Developing messaging technologies
• Network development and optimization
• Building QA or testing environments
• Integrating disparate or legacy systems with new software

By claiming any of the above-qualified activities towards the research credit, taxpayers will be able to offset some of the §174 amortization.