Geoffrey Kayton, CPA
12.27.21 | TAX Chat
The Internal Revenue Code (IRC) provides a credit for ‘certain research expenses’ (QREs), the intention of which is to spur domestic technological development. The determination of qualifying expenses, and calculation of the associated credit, can be difficult. There is an important change to the tax treatment of QREs starting with tax year 2022. This post is a summarized analysis of the research credit and how these concepts apply to software development.
Qualified Research Expenses
QREs are business research and development costs which are technical in nature or done to improve a product, process, computer software, technique, formula, or invention. That is a very simplified definition; the QRE rules are extremely nuanced and complex. QREs can include amounts paid for wages, contracted research (at 65%), and supplies. Examples of disqualified expenses include research after commercial production, clinical testing, reverse engineering, surveys, studies, and non-domestic. Properly documenting research activity components is a must to maximize the tax benefit.
As with the rules governing QREs, the research credit computation is complex. To qualify for the credit, you must incur the QREs domestically. There are two ways of computing the credit (regular and alternative), and there is an election of reduced credit, all of which usually yield different amounts. Regular and alternative methods compute a baseline, then test current year expenses for an increase. The increase is then used to compute the credit. Assuming adequate annual increases, the credit is at least 10% of current year QREs. The expense or asset attributable to the QREs is reduced by the credit for purposes of calculating taxable income. You can make an election to reduce the credit by 21% and use 79% of the credit. By electing the reduced credit, you do not need to reduce the amount of the expense or asset attributable to the QRE. More simply, the election allows a taxpayer to choose reduced taxable income instead of the full credit.
QREs can include amounts paid to develop software, which is for sale, lease, or use in a trade or business, and has not reached commercial production (among other requirements). If for internal use, the software must meet a more stringent set of requirements. Amounts paid to adapt an existing product do not qualify, so changing existing software to meet customer standards probably does not qualify.
The inclusion of software development in QREs has historically been by way of Internal Revenue Service (IRS) guidance, which was more recently codified in the Internal Revenue Code by the Tax Cuts and Jobs Act (TCJA). The TCJA changes, which are applicable to all QREs and to tax years starting 2022, also affect the tax treatment. Historically, taxpayers could deduct QREs in the year paid or incurred; the changes require capitalization and 5-year amortization (15 years if foreign or by election), which begins at the midpoint in the year paid or incurred. Also, in the event of a disposition, retirement, or abandonment, the adjusted basis cannot be deducted any faster than the original 5-year life.
The determination and subsequent tax treatment of QREs are complex. QREs have historically qualified for a credit and could be deducted in the year paid. Going forward, QREs must be capitalized and amortized over 5 years (even if abandoned) but still qualify for a credit. The larger the project, the more it makes sense to involve an expert in the determination of the amount of QREs and credit. Software development – even for internal use (subject to tougher restrictions) – can qualify as a QRE. In planning for the next project, which qualify as qualifying research, reach out to your Berdon advisor to ensure maximum tax benefit.
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Geoffrey Kayton is a Senior Tax Manager with more than 10 years of professional experience. He advises a diverse array of clients across the real estate sector on a variety of tax matters.