Application of the 4 Part Test to Software Development

When conducting an R&D tax credit study, one of the first things any consulting firm will do is determine whether their client’s work meets the 4-part test requirements laid out in IRC Section 41. When it comes to software development, this test is extremely important, as it helps companies rapidly assess which aspects of their product development will qualify.

Although the IRS is very particular about what is defined as qualified research activities (QRAs), software development is one of the most common industries to qualify for the R&D tax credit. This is why the four-part test analysis is so effective (and necessary) to perform at the beginning of the qualification process. The four requirements are summarized below.

Part 1: Permitted Purpose

Small businesses and startups that invest resources to design and develop new software can claim R&D credits. Additionally, investments to improve the software with new functionalities or capabilities are typically qualified research expenses (QREs).

For example, a company can claim R&D credits for developing the 1.0 version of a software platform, as well as the investment of time and resources into making enhancements for version 2.0 (and 3.0, etc.). Rarely does a company stop developing software after the first version, and the subsequent software development lifecycles (SDLC) also qualify.

Part 2: Technical Uncertainty

The project or development must attempt to resolve technological challenges or eliminate uncertainties. A technological uncertainty is applicable if the company’s available knowledge and information is insufficient or lacks depth to meet the software’s requirements and specifications. Software development fulfills this requirement since development teams do not know the optimal code design or coding methodology at the outset of the project.

Part 3: Process of Experimentation

A substantial part of the company’s activities undertaken to develop the software demonstrate a process of experimentation. That is, a series of trial and error designed to evaluate alternative solutions to achieve the desired permitted purpose. This can also include a regimented SDLC methodology and/or stage-gate process.

Part 4: Technological in Nature

The activities undertaken throughout the SDLC fundamentally rely on principles of the physical or biological sciences, engineering, or computer science; the last of which is the root of software development.

The High Threshold of Innovation Test

The R&D tax credit can also be applied for development of Internal Use Software (IUS) and its implementation. The development must satisfy an additional three-part test to ensure that the internal software development expenses qualify for the tax credit. These include:

1. The Innovation Test: The software must be innovative; that is, it is intended to be unique or novel and to differ significantly from prior software implementations or methods.
2. The Economic Risk Test: The software development effort must entail significant economic risk. In other words, the company must commit substantial development resources and there is also uncertainty because of the technical risk as to whether these resources will be recovered within a reasonable time.
3. The Commercial Availability Test: The software must not be commercially available. No currently available software could be used for the intended purpose without significant modifications that meet the requirements in the first two tests.

If Your Company Is Developing Software, Chances Are It Qualifies

Software development is one of the fastest growing industries in the world, and companies developing software typically meet the 4-part test requirements. The primary issue companies face is accurately quantifying activities and expenses. This is where the experienced advisors at Strike Tax come in.

Let us help you generate additional funds to reinvest in your company, expand your workforce, and take your ideas to the next level. Contact us today to see how we can help, and use our credit calculator to see how much you could be saving toward your tax liability.