If 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.
What is the R&D 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.
How to qualify your SaaS company for the R&D Tax Credit
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.
New or Improved Technology
Are you building something that advances an existing software technology? Are you improving upon a software to make it better? Or are you building a software application that’s completely new to the world? All of the above will qualify!
Let’s say you make a plug-in that makes Spotify stream with a higher clarity rate, that's improving upon existing technology.
Are you experimenting, trying new ways to solve existing problems? Can you show that a dev is working in a new space, trying something that's not been done? If you're building something new, this takes time.
You also aren't promised that this idea will work, so there's an allowable failure rate that comes with pushing for new boundaries.
Process of Experimentation
Experimentation occurs when the means of achieving the desired objective is not readily discernible at the outset. The process of experimentation (POE) is identifying and evaluating alternatives, performing trial and error experiments,and testing results. The IRS also considers “process of experimentation” when a candidate creates prototypes, models and simulations.
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:
- Developing or improving an existing software; for commercialization or internal use
- Programming and testing source code
- Developing product feature enhancements
- Creating new or specialized technologies
- Improving performance and optimizing functionality
- Creating, designing, and developing software architecture
What SaaS activities won’t qualify as R&D are things like:
- Development performed outside of the US and US territories
- Software application configuration
- Routine maintenance
- Post-release bug fixes and routine quality control testing
- User interface or experience development for purely aesthetic design
What Expenses Qualify
For a software company, you can include three buckets of expenses in the R&D credit calculation.
1. W2 Wages
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:
- Chief technology officer
- Software and database architects
- Software engineers and developers
- Computer and data scientists
- Quality assurance testers
2. Contract Research (1099s)
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.
3. Cloud Computing
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.
Let's talk cold, hard cash
The R&D tax credit can make a significant difference in your bank account. Due to its powerful capabilities, the tax credit can offset:
- Federal and state tax income liabilities
- Payroll tax for Qualified Small Businesses
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 $250,000 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.
Claiming the R&D Tax Credit for your SaaS company
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, you're going to need to work with someone who knows the ins and outs of claiming the credit– like us. 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.