Planning for potential software projects can be complex and time-consuming, but it’s a critical first phase in the software development life cycle for commercial software vendors. Fortunately, the time spent on many of these activities could reduce your company's tax liability through the R&D Tax Credit. Qualified research expenses provide a great opportunity for software companies to recoup some of the costs associated with this initial planning phase as well as subsequent phases of the software development life cycle.
As a commercial software vendor, if you are developing or have recently developed new or enhanced software, there are bound to be activities that qualify for the R&D Tax Credit. One of our previous blog posts highlighted all seven phases of the software development lifecycle.
The first phase of the software development life cycle typically begins by defining the business problem and/or goal and determining potential solutions. This phase concludes by estimating the market opportunity and return on investment. Each of the activities throughout this phase should be run through the Four-Part Test (below) to identify activities with qualified research expenses.
Typical questions to be answered in this planning phase include:
- What is the business problem to be solved?
- What approach should we take to solve the business problem?
- What are the primary capabilities, functions and features?
- What benefits will the users receive?
- What resources are required?
- What are the costs?
- How much time will it take?
- What does the competitive landscape look like?
- Does this give us a unique competitive advantage?
- Will this help prevent competitors from entering the market?
- What’s the size of the market?
- What’s the estimated return on investment?
The Four-Part Test
To determine which activities and their associated expenses may qualify for the credit, run them through the Software Industry’s Four-Part Test. The four parts of the test are:
- Permitted Purpose. This is the activity intended to make or improve either a product or process that results in improved function, performance, reliability, quality or cost efficiency.
- Technical Uncertainty. This is the activity intended to eliminate technical uncertainty when developing or improving a product or process related to methodology, design, techniques, formulas or inventions.
- Process of Experimentation. This is the activity that includes a process of experimentation to eliminate or resolve technical uncertainty. During the process, various alternatives and approaches are evaluated by modeling, simulation, trial and error, prototyping and other methods.
- Technological in Nature. The process of experimentation must rely on the hard sciences (engineering, physics, biology, chemistry, computer science).
The R&D tax credit was created to encourage the development of new and/or improved products or processes, including software. Always consult with an R&D Tax Credit expert with deep software expertise for a complete understanding of how this credit can reduce your tax liability.
If you are interested in pursuing the R&D Tax Credit for your software business, contact Black Line Group to discuss your planning phase and we can jointly determine how various activities pass the Four-Part Test.