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Inside: The strategic guide to R&D tax credits for SaaS. Transform your financial landscape and supercharge your business growth.
Tax and CreditsIf there's one trend in the digital world that's gone from outlier idea to widespread adoption in the last decade, it's SaaS. SaaS became the go-to model because of one central principle: keeping customers happy with manageable monthly prices.
Gone are the days of high yearly costs because now, companies play a long game rather than hope you like the product or service. By keeping services affordable, adoption is higher.
It's time to acknowledge this model's impact on everything – SaaS companies drive innovation every day, and our world moves faster thanks to them. Remember paper maps or answering machines?
We can thank software companies for so many things that make our lives easier on a daily basis. Zoom, your CRM, Slack, your calendar scheduling tool, and so much more. But none of these breakthroughs was an overnight success, and it took time, failure, and planning to see tangible results.
What a lot of SaaS companies don't realize however, is that they can get significant tax breaks for the time and money spent to see their software come to fruition. This tax break comes in the form of what’s called the Research and Development tax credit.
Let’s dive into how to know if your SaaS company qualifies for the Research and Development tax credit.
To start, let’s go over a quick overview of the R&D credit (for a much more in-depth overview, check out our ebook).
In 1981, the IRS created the R&D tax credit under The Economic Recovery Tax Act (ERTA) to jump-start economic growth and incentivize businesses to keep tech jobs in the United States. At first, the credit was only temporary, but because it was so successful, it was made permanent under the Protecting Americans from Tax Hikes Act (PATH) back in 2015.
And thanks to that permanence, the tax credit allows SaaS businesses to reduce federal and state tax liabilities and earn back up to 10% on what they are spending on product development!
The R&D credit also allows your SaaS business to go back three years for federal (similar to most states) taxes and allow businesses to amend prior year tax returns to claim all development costs and unclaimed tax credits.
Truthfully, most software development (with some exceptions) activities qualify for research and development tax credits. But let’s go over the four things you need to prove to show that the software you’re developing qualifies.
When it comes to qualifying for R&D tax credits in the field of software development, the key is whether you're creating new technology, or significantly improving existing technology. This can include enhancing a current software's performance, functionality, or other key features, or developing an entirely new software application that introduces something novel to the market.
For example, if you're working on a project that advances the capabilities of existing software technology, this can qualify. Let's say you're creating a software plugin for a popular music streaming service like Spotify. If your plugin enables Spotify to stream music at a higher clarity rate than previously possible, this is a clear case of enhancing existing technology. You're not just making minor tweaks; you're significantly improving the quality of the music streaming experience.
Alternatively, you might be developing software that does something completely new – something that hasn't been seen before in the digital world. This could be a groundbreaking app that introduces a new way to interact with digital content, a novel data analysis tool that leverages AI in a way never done before, or a unique security protocol that significantly enhances digital safety.
Whether you're elevating existing technology to new heights or introducing something entirely new, both paths represent valuable contributions to the advancement of software technology. Such endeavors often involve overcoming technical challenges or uncertainties, which is a core criterion for R&D tax credits. By pushing the boundaries of what's possible in software, you're not just contributing to your field – you're also engaging in the kind of innovative work that R&D tax credits are designed to encourage.
Technological uncertainty is a key factor when it comes to qualifying for R&D tax credits, especially in the software development sector. This concept revolves around the idea of experimentation and innovation – are you exploring new methods to solve existing problems through software? It's about venturing into uncharted territory, where the solutions are not immediately obvious, and the outcome is uncertain.
For instance, imagine your development team is working on a project that involves a new algorithm or a unique approach to data processing. This project could be pushing the boundaries of current software capabilities or exploring a new application of technology. The key here is that there's no guarantee of success. You're not just following a well-trodden path; instead, you're trailblazing a new one. This inherent risk of failure is a hallmark of technological uncertainty.
This is particularly relevant in the Software as a Service (SaaS) industry. When developing a SaaS product, you might be creating something entirely new or significantly different from existing offerings. The development process involves research, trial and error, and iterative testing. Throughout this process, there's no certainty that your final product will work as intended, or even be feasible. This level of uncertainty and the need to overcome it through systematic research and development efforts are exactly what R&D tax credits aim to support.
The concept of allowable failure rate is also crucial in this context. It acknowledges that not every innovative attempt will result in success, and that's perfectly acceptable. What matters is the effort to push technological boundaries and explore new possibilities. Whether it's enhancing user interface design, increasing software efficiency, or developing entirely new functionalities, the journey through these uncharted technological waters is what qualifies for R&D tax credits.
In the realm of Software as a Service (SaaS), experimentation is a crucial process, especially when the path to the desired software solution isn't clear from the start. This process, known as the Process of Experimentation (POE), involves several key steps.
Initially, it's about identifying different ways to achieve the software's goals – these could be various coding approaches, algorithm designs, or architectural frameworks. Then, the team engages in a period of trial and error, where these different approaches are tested and tweaked. This might involve writing and rewriting code, adjusting software architecture, or experimenting with different user interface designs.
The Internal Revenue Service (IRS) pays special attention to these activities in the SaaS industry. They recognize the creation of prototypes, models, and simulations as part of the POE. In the context of SaaS, a prototype could be an early version of a software application, used to test functionality, user experience, and overall performance. Models might include computational models that predict user behavior or software performance under various conditions. Simulations, on the other hand, are used to mimic real-world scenarios where the software will operate, to test how well the software performs in different environments or under various stress conditions.
These activities are critical in the SaaS sector, where software needs to be robust, user-friendly, and capable of operating in diverse and often unpredictable environments. The process of experimentation in SaaS is not just about building a functional product; it's about innovating and pushing the boundaries of what software can do. This is why such activities are often eligible for R&D tax credits, as they embody the essence of research and development in the digital age.
Can you show that your activities are based in the hard sciences or computer sciences? With SaaS this one is pretty obvious!
Overall, for your work to be considered innovative, you need to show specific elements of creating something new or improved, provide a view into the real risk of failure, and showcase the challenges of what you're trying to achieve — hence "R&D."
For a SaaS company it might look like one, or several of the following activities:
For a software company, you can include three buckets of expenses in the R&D credit calculation.
Employee wages for R&D activity, as well as supervision or direct support of such activity, may be included in the credit. If employees spend at least 80% of their time performing R&D, all of the employee compensation may be included in the credit calculation.
Employees this often applies to for SaaS companies include:
When starting out, software companies often employ contractors to perform development-related tasks. For contractors and consultants, up to 65% of expenses may be included in the credit calculation, provided that the work is performed in the United States or US territories.
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With the advent of cloud computing, software companies often incur cloud expenses for hosting their servers. For this, think Google Cloud, Heroku, AWS, etc.
So, if a SaaS company leases multiple servers for their development, expenses for the non-production, or staging server may be included in the credit.
The R&D tax credit can make a significant difference in your bank account. Due to its powerful capabilities, the tax credit can offset:
Using the credit against payroll taxes can be a major benefit for early stage SaaS startups as many may not yet pay income taxes but do pay payroll taxes. For these companies, up to $500,000 of the R&D credit may be applied to a portion of its social security (FICA) payroll tax each year, provided that certain criteria are satisfied.
Qualified small businesses include:
A company that has less than $5M in gross receipts in that eligible year. Gross receipts for no more than five years.
If you're a SaaS startup, these kinds of possibilities could change fortunes. You don't even need to be in a profitable tax position to see fundamental changes for future projects as pre-revenue companies can offset payroll taxes the quarter after claiming, which is enormous.
Software development is common in claiming the credit because they invest so many resources to design and develop new products. So, if your SaaS company is taking risks to create something new or improve upon an existing product or service, you'll most likely qualify for the R&D tax credit!
Like with all companies claiming the R&D credit, you’re going to need to be a paper trail, and one thing you may not realize how you're building and growing is located right in your code repositories like JIRA, BitBucket, or GitHub. All these are trackable!
Just make sure the documentation should be from the time development was done and it proves that the work occurred in the fiscal year you are claiming the credit! It should highlight the technical challenges to substantiate the R&D that was done and who was involved.
Also, since the R&D credit can get a bit technical, with even some states having their own R&D credit programs, you're going to need to work with someone who knows the ins and outs of claiming the credit– like us, the R&D tax credit experts. TaxTaker can provide detailed documentation and calculations. We know what to do, what you'll need to show, and how to make sure everything will go smoothly. (We've been doing this a long time.)
If you're a SaaS company looking to take advantage of this massive tax win, we can help.
Under the recent changes to Section 174, effective for tax years beginning after December 31, 2021, businesses must now capitalize and amortize R&D expenditures, including software development costs. This shifts from the prior practice of immediate deduction and affects SaaS companies significantly. They face increased taxable income due to the longer period over which R&D costs are amortized (five years domestically, fifteen years for foreign costs).
However, it is important to note that these changes do not impact the R&D tax credits under Section 41, which SaaS companies can still claim.
Yes, software development often qualifies for R&D tax credits, particularly if it involves innovation, improvement, or technological challenges. Projects must meet specific criteria, such as advancing technology and resolving scientific or technological uncertainties.
The R&D tax credit for technology companies, including SaaS, provides tax offsets for costs incurred in developing new or improved technology. Eligible costs include wages, supplies, and certain overhead expenses related to R&D activities. The credit's size depends on the extent of qualifying R&D expenditures.
In SaaS companies, Qualifying Research Expenses typically cover software development, product innovation, technological research, and improvement costs. This includes salaries for R&D staff, costs of prototypes and testing, software development tools, and other related expenses essential for advancing technology and product offerings.
The ideal R&D spend for a SaaS company varies as there's no fixed rule for R&D spending. It is widely influenced by factors like company size, growth stage, and market conditions. Early-stage companies may invest more heavily in R&D, sometimes over 50% of their revenue, while more established firms might allocate a smaller percentage.
The R&D ratio for SaaS companies, indicating R&D spending relative to total revenue, varies greatly. While there's no standard ratio, it's not uncommon for SaaS companies, especially in growth phases, to have higher ratios, reflecting significant investment in product development and innovation.
Matt Bechtold heads up TaxTaker's R&D credit practice. He has helped companies claim valuable Federal & State R&D credits for more than 10 years for a wide range of clients and industries, ranging from Fortune 500 companies to startups and medium-sized businesses.
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