by Wendy Landrum et al.
Baker Tilly Virchow Krause, LLP is an IMA Member
Historically, insurance companies have not been prime candidates for the research and development (R&D) credit, a tax credit available to companies that develop or improve new products or processes, with the exception of the development of new policy administration systems. Under the R&D credit rules, these policy admin systems would be considered internal use software (IUS) used for general and administrative functions facilitating or supporting the conduct of the business – “back-office functions” like financial, human resource management and support services.
In order to be eligible for the R&D credit, IUS must meet, along with the general four-part test requirements (must be technological in nature, for a permitted purpose, involve the elimination of uncertainty and include a process of experimentation), an additional three criteria – must be innovative, must involve significant economic risk and may not be commercially available for use. Although there are regulations for this high threshold of innovation test, IUS is closely scrutinized by the IRS.
Wages and contract research costs associated with R&D projects and activities are included in the credit. For many traditional insurance companies developing policy admin systems, the company does not have in-house computer scientists/software engineers and uses third-party contractors for the software development. Often, the contractors are paid on a fixed fee basis for business reasons (versus hourly/time and materials). These costs may not qualify as the company does not have financial risk in the success of the development by the contractor.
Considering the potential IRS risk associated with IUS and the disadvantageous payment terms to third-party contractors, traditional insurance companies generally have not been able to capture the R&D credit benefits on millions of dollars of development spent.
Enter InsurTechs – insurance companies that use technology and innovation to reach their customers through digital platforms to increase efficiencies and savings. Because these new digital platforms are used to provide computer services to customers, the software development should not be subject to the high threshold of innovation test under the IUS rules discussed above.
Examples of qualifying software development activities include:
- Designing and developing new products and/or product enhancements
- Developing product specifications or requirements, such as functional, design or test specifications
- Designing and integrating applications and technologies
- Developing new or improved technologies (e.g., new algorithms or methodologies)
- Designing, developing and testing client-specific applications
- Designing and developing software architecture
- Programming software source code
- Conducting functional and/or technical testing to validate design
- Compiling and testing source code
Unlike the short-term need for third-party contractors to develop a policy admin system, InsurTechs have their own teams of computer scientists/software engineers to do the coding and development. Not only does this eliminate the need to evaluate the contractor financial risk, qualified employee time is captured at 100 percent versus a 65 percent haircut of contractor costs, significantly increasing the credit.
With the advancement of innovative software development platforms that are “low-code” or “no-code,” we will continue to see more citizen developers emerge in organizations – decreasing the level of effort traditionally needed for software development and testing. However, these platforms require significant R&D work to ensure the end users are working with intuitive and user-friendly tools. Furthermore, organizations must still consider the primary roles of the application creators (professional versus citizen developer), the types of applications needed (data-centric versus process-centric) and the complexity of the resulting apps (simple and easy to template versus complex and fully custom).
Since many InsurTechs are startup companies, they may also be eligible for the R&D payroll tax offset. Because the R&D credit is a nonrefundable credit, startup companies are often limited in their ability to claim the R&D credit in the current tax year because they do not have current income tax liability to otherwise offset the credit. The company receives no immediate tax advantage from the R&D credit, especially for years in which R&D activities may be high.
The Protecting Americans from Tax Hikes (PATH) Act of 2015 allows certain small businesses to offset the R&D credit against payroll taxes instead of income taxes. Up to $250,000 of annual federal R&D credits can be allocated against payroll tax liability for tax years that begin after Dec. 31, 2015.
To qualify in 2018, a business must have gross receipts of less than $5 million in 2018 and may not have had gross receipts for any tax year before the five-tax-year period ending with 2018. For example, if the credit-claiming year is 2018, a company must have had less than $5 million of gross receipts in 2018 and no gross receipts prior to 2014.
As InsurTechs expand their platforms and development teams, the R&D credit may grow exponentially. Generally, the federal R&D credit equates to about 5 to 7 percent of eligible R&D expenses. The ability to monetize the R&D credit through the payroll tax offset increases cash flow as well as the ability to increase investments in team members and new technology.
Baker Tilly has an experienced team of R&D professionals who will work with you to develop an efficient and cost-effective approach for identifying and documenting eligible R&D activities and costs. We have assisted many InsurTech clients in identifying, documenting and sustaining federal and state R&D credits through a comprehensive understanding of their business operations.
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