The software industry is one that benefits deeply from the R&D tax credit, yet the surprising reality is that an overwhelming number of video game companies are not pursuing the credit at all, says BDO USA's David Wong.
In 2010, a three-person game development company in San Francisco reduced its tax bill by over $300,000 after a game went live, and the company became profitable. How?
R&D tax credits.
The three founders had no idea that the software development activities they had been performing in their apartment while creating their new social networking game qualified for such a credit. Nor were they aware that the amounts they received from their company that year after the game's success constituted qualified wages for purposes of the Research and Development credit.
The software industry is one that benefits deeply from the R&D tax credit
, but video game development companies, including small- to mid-sized companies and start-ups, are also in a position to reap the rewards of this lucrative tax benefit. Video game development has evolved to become one of the most complex disciplines in software development, but many companies are not aware of their eligibility to take advantage of these credits.
The surprising reality is that an overwhelming number of video game companies are either not pursuing the credit at all or are not receiving their full cash-savings. According to the U.S. Government Accountability Office, the credit is claimed mostly by large corporations, which suggests that small- to mid-sized companies are overlooking it. This could be a result of not knowing that the credit exists or that their activities are qualified.
Developing a video game demands a high level of artistic and technical skill. For this reason, the field attracts technical engineers and artists alike. The driving force behind some of the best games on the market is a high-functioning symbiosis of technical skill, creativity and artistic prowess. While one person may possess all these skills, most don’t. Therefore, it is important to analyze the development process in its entirety to understand its various stages, the individuals involved, and the activities it entails to understand whether and to what extent they qualify for the R&D tax credit.
The R&D tax credit was first established in 1981 to stimulate domestic economic growth. It provides funds to companies that incur expenses to try to develop or improve their products, processes, software, techniques, inventions, or formulas. The manufacturing, food, pharmaceutical, biotechnology, energy, and transportation industries have historically been heavily entrenched in these kinds of activities.
For years, though, video game and console developers have been as well. Due to the technical software/hardware development activities related to such things as uncertainty about product design, and bringing a game to the commercial marketplace, video game developers are often performing qualified activities. That makes them just as prime a potential beneficiary of the credit as companies in other industries.
The R&D tax credit can be a powerful tool to help offset tax liability, improve cash flow, and even fund future projects. If claimed appropriately, R&D tax credits can provide meaningful cash-savings for a company with one employee, to one with thousands. R&D tax credits can enable companies to generate up to 15 percent of their qualified spending to offset their tax liabilities from both federal and state R&D credits. And it’s no secret that successfully bringing a new game, software engine, console, mobile app or handheld to market requires that a company pursue every avenue necessary for increasing its cash flow.
What does the two or three-person start-up or global video game leader need to know to obtain the full cash-savings available through the credit? It comes to a few simple questions.
Is your company eligible?
The first step is to ask how your company is involved in the process of video game development. If your company participates in any phase of software development, design, testing, debugging, troubleshooting, or any process involved with developing the game, console, handheld device or mobile app, then your company may be eligible.
Typically, companies are eligible if they have employees or contractors that are:
o Game Designers
o Level Designers
o Sound Designers
o Software Engineers
o Graphic Designers
o QA Analysts
Similarly, companies that attempt to develop or improve the functionality or performance of components like the following are typically eligible:
o Game consoles
o Mobile gaming
o Tablet games/apps
o Game artificial intelligence (AI)
o Game production tools
It's important to note efforts to make these improvements do not have to succeed to qualify. And, you don't have to be trying to revolutionize the industry to qualify. Attempting to develop incremental, evolutionary improvements is eligible as well.
How big is the credit?
While the credit amount ranges depending on a number of factors, companies that attempt to develop new or improved products and software typically receive federal and state R&D tax credits and incentives that are up to 15 percent or more of their qualified spending.
Dollar-for-dollar offsets against regular income tax liability, these benefits have enabled start-up and mature businesses to expand their labor force, invest in new technologies, and finance other business objectives.
And if you're not paying taxes you can still benefit from R&D credits. For example, many states will pay you the value of your credit. Additionally, the federal and state credits can be carried back to earlier and forward to later tax years, when they could be used to offset past or future tax liability.
Is the president or CEO eligible in addition to your software developers and programmers?
The simple answer is: Yes. Regardless of job title, if you, or your employee(s), perform any qualified activity, or directly supervise or support employees who do, then you and they could qualify. Many start-ups or small to mid-sized companies can operate only if their employees "wear many hats," which is why it is imperative to examine thoroughly the job functions of each employee. This may reveal that even the CEO, or other executives, are contributing to the development and testing process.
Is there any risk in claiming R&D credits?
When properly reported, the risk of claiming an R&D tax credit is primarily that a tax examiner will disallow the credit, and that you'll be out the time and any expenses you incurred to claim it. When improperly reported, tax examiners can impose penalties for underpaying your taxes.
In general, the difference between properly reported claims and improper ones is that the former have documentation to support them, the latter do not. Some of the types of documentation tax examiners want to see include financial records, such as W-2s, invoices, and contracts, as well as technical documentation generated while employees or contractors are performing their development activities, evaluating alternatives, experimenting, testing, etc.
Thousands of businesses of all sizes reported R&D credits in 2009 of over $8.3 billion. If you're attempting to develop or improve your video game, console, or handheld, you might be eligible for the credit, which could help you drive your company’s future growth.
David Wong is a Senior Director with BDO USA, LLP's R&D Tax Services Practice. He can be contacted at [email protected]