As a result of the COVID-19 pandemic, state and local mandates to ‘shelter in place’ have required businesses to rapidly build out new technological capabilities, such as e-commerce and remote work functionality. With the economic tumult caused by the COVID-19 outbreak, businesses are looking for ways to conserve cash and limit expenses. The Research and Development (R&D) Tax Credit is a prime opportunity to decrease tax liability, retain cash and recoup some of the expense of technology investments necessitated by the outbreak.
Through the R&D Tax Credit, companies can offset their tax liability based on a percent of qualified annual research expenditures that exceed a base amount. In addition to the federal credit, many states offer local R&D tax credits, with parameters that closely mirror the federal program. Qualified research expenses (QREs) include:
- Employee wages to conduct, supervise or support qualified research
- Consumable supplies used in conducting the research
- Payments to third-party contractors performing research on the company’s behalf
For an activity to meet the definition of qualified research, it must meet the following four criteria:
- Be for the purpose of developing a new or improved function, performance, reliability or quality of a ‘business component’ (i.e., a product, process, formula, technique, invention or software).
- Rely on information that is technological in nature (using principles of physical science, engineering or computer science);
- Be intended to eliminate technical uncertainty, based on information available to the taxpayer at the outset of the project; and
- Constitute a process of experimentation focused on evaluating and testing one or more alternatives.
The research does not have to be successful in order to claim the R&D Tax Credit. The credit is based on efforts, not results.
One prevalent response to COVID-19 has been the buildout of e-commerce functionality. Whether your business has existing e-commerce capabilities or this is your first foray into e-commerce, software development activities related to the deployment and scale-up of this functionality can qualify for the R&D Tax Credit. For example, many financial institutions offer e-banking services via mobile applications. In response to COVID-19 social distancing recommendations, they may decide to add functionality in order to offer additional services via the mobile application that are typically conducted in-person. In another example, health providers may decide to add functionality to enable the practice of telemedicine.
Another prevalent response to COVID-19 has been the buildout of remote work and virtual collaboration functionality. This includes home-grown systems as well as custom software development necessary to implement commercially-available options like Jabber, Skype and Microsoft Teams. Rolling out virtual collaboration for the first time typically involves significant back-end work to connect the collaboration tool of choice to the company’s existing systems and environment without compromising cybersecurity. Companies with existing remote work capabilities may find their system unable to handle the load from a significant portion of their workforce working remotely. They may need to undertake additional technology investments and system reconfiguration to adapt to this challenge.
In addition to the offset of income tax liability, the federal R&D Tax Credit provides a key incentives to eligible small businesses. Businesses with less than $5 million in gross receipts in the current taxable year and zero gross receipts prior to the five-year period ending with the current tax year can offset the employer portion of Social Security tax by up to $250,000 each year.
