There are some great tax deductions and tax credits out there for video game developers. Electronic Arts made the front page of the New York Times a few years back based on reporting that its use of a combination of tax credits and deductions resulted in paying $98 million in taxes worldwide on global profits of $1.2 billion for 2006-2011. However, these tax incentives are not just for behemoths such as EA, and they can be powerful tools to maximize up-front after-tax profits for independent and/or startup video game developers.
In the following three articles, I am going to cover the three main deductions and credits for software developers: (1) the 100% deduction under section 174; (2) the 20% Research & Experimentation Tax Credit under section 41; and (3) the 9% domestic production tax deduction under section 199.
The Research and Experimentation Credit is more widely known as the R&D Credit. There are two main differences for software developers between the tax credit and the deduction: (1) an economic difference, and (2) a calculation difference.
Economically, the credit is a dollar for dollar credit against the taxes that you owe as opposed to a dollar for dollar deduction against your income. For example, if your tax rate is 35% and you have a $1 million dollar deduction against $10 million of income, then your deduction will lower your tax bill by $350,000. By comparison, if you have a $1 million dollar credit, then your credit will lower your tax bill by $1 million. Therefore the credit is better from an economic standpoint.
However, it is more difficult for expenses to qualify for the credit and the credit has stricter limits than the deduction. In the following post I will show how the credit works for a startup company.
How to Calculate the R&D Tax Credit for a Startup Software Company
The first step is that the expenses have to qualify for the R&D credit. To qualify for the credit, the expenses must be qualified research expenses by meeting the following requirements:
- The expenses must qualify under IRC section 174. Fortunately, all software development fall under IRC section 174.
- The purpose of the research must be to create new software or improve existing functionality, performance, reliability, or quality of computer software that the researcher intends to sell, lease, license, or use in their trade or business.
- It must be technological in nature. What this means is that the research must rely on principles of, among other things, computer science. So as long you're expanding or refining computer science, you're on the way to claiming the credit.
- The activities must involve the process of experimentation to create or improve the function, performance, reliability, or quality of the technology. Essentially, you have to propose a hypothesis and test the hypothesis, or, in other words, the result must be uncertain.
If you're a software developer, you should be able to tell that a lot of your day-to-day activities could qualify for the R&D credit. Among the types of software development activities that could qualify for the credit:
- Designing the software
- Testing different coding solutions
- Beta testing
- Adding new features
- Code optimization
- Bug tracking
- Flow charting
- Database design
As you can see, there are a lot of credit options!
There is one major software development activity that cannot generally be used to claim the R&D credit: development of internal use software. However, there is an exception and the internal use software credit can still be claimed if the following three additional requirements are met:
- The software must be unique or novel, and be intended to differ in a significant and inventive way from prior software;
- The software development must involve significant economic risk in that it involves a significant commitment of resources and it is uncertain whether this cost can be recovered within a reasonable period; and
- The software must not be commercially available.
CRUCIAL STEP: Documenting Your Expenses
As you can see, there are strict requirements for expenses that qualify for the credit, but a lot of the expenses in software development qualify. In order to make sure that you can claim the credit that you are due, it is absolutely necessary that you keep detailed records of your expenses. The IRS can closely scrutinize claimed R&D credits, and your books MUST document that your expenses actually meet the requirements.
Calculation of the R&D Credit for a Startup Company
The R&D tax credit can be claimed in the first year in which a company has both gross receipts and qualified research expenses. To calculate your credit for the first 5 years beginning with the year in which you first qualify, you follow the three following steps:
Step 1: Calculate your fixed base percentage (FBP). This amount is fixed for the first 5 years of a startup at 3%.
Step 2: Determine your base amount (BA) by calculating the greater of your base amount (YBA) and your minimum base amount (MBA). The YBA is equal to FBP times your average gross revenue over the past four years. The MBA is equal 50% of your current year's qualified research expense (QRE).
Step 3: Calculate the credit by using the following equation:
Credit = 20% x ([current year QRE] - BA)
In 2011, startup company ABC has revenue of $20,000, and QRE of $36,000. In 2012, ABC has revenue of $40,000 and QRE of $30,000.
Step 1: The FBP is equal to 3%.
Step 2: BA is equal to the greater of the following:
ABC's YBA = 0.03 x ([20,000 + 40,000] / 2) = 0.03 x 30,000 = $900
ABC's MBA = 0.50 x $30,000 = $15,000
BA = $15,000
Credit = 0.20 x (30,000 - 15,000) = $3,000
Like just about every tax incentive, the R&D tax credit is not a dramatic windfall for developers. But every penny always counts, particularly when you're just starting out.
William Lewis is a tax and business attorney based in the Silicon Valley. He advises domestic and foreign clients on a range of business, tax, and estate planning matters. You can reach him by email at lewistaxlaw[at]gmail[dot]com.
Originally published at the Global Law & Business Perspective.