Software Development Tax Benefits for Insurance Companies in 2024

Many recent tax changes surrounding software development have the potential to benefit companies in the insurance industry. One specific change is the requirement to capitalize and amortize Section 174 research expenses over 5 years for domestic and 15 years for foreign expenses, which kicked in for tax years after 12-31-2021.

Insurance companies often overlook another powerful tax savings opportunity because most do not believe they perform any qualified research and development (R&D). However, this cannot be further from the truth. In fact, software development is the most common qualifying activity for the R&D tax credit for insurance companies.

JLK Rosenberger breaks down these key changes and additional tax benefits available for insurance companies performing software development below.

Section 174 Amortization Requirements & Legislative Updates

Congress has traditionally reviewed a tax extenders bill at the end of each year. Since November 2023, Congress has debated comprehensive extender legislation designed to address several provisions of the Tax Cuts and Jobs Act (TCJA), including the requirement to capitalize and amortize Section 174 research and development (R&D) expenses.

Historically, expenses related to software development could be expensed in the year paid or incurred with the option of also amortizing the expense over 60 months from completion or 36 months from when it was placed in service. The TCJA change specified that costs related to software development must be treated as a Section 174 expense and had to be capitalized and amortized over 5 years for domestic R&D amounts.

In January, Congress passed the Tax Relief for American Families and Workers Act of 2024 to address these TCJA changes. One retroactive change effective for tax years ending after December 31, 2021, would temporarily restore the current year’s expensing of Section 174 domestic research up until December 31, 2025. Software development costs are still specified in the legislation as a 174 expense, and foreign research amounts must still be capitalized and amortized over 15 years. However, if the bill passes, insurance companies engaged in software development would have the option of expensing these costs in the current year or capitalizing and amortizing a portion or the entirety of the costs for a minimum of 60 months over the useful life of the software.

The current text of the bill does provide for transition rules allowing a taxpayer to implement these changes retroactively, including allowing taxpayers who claimed 174 costs in tax year 2022 to make a Section 481 adjustment on a modified cut off basis for the remaining amortized amounts on the current year return.

Another change is an amendment regarding Section 280C to a pre-TCJA version that specifies a taxpayer must reduce Section 174 deduction by the current year’s R&D credit amount. This would not affect taxpayers who elected 280C on their 2022 tax returns, and the bill text may allow for this to become effective in tax year 2023 versus requiring changes to 2022 returns. Otherwise, taxpayers who did not elect 280C may need to adjust, as the prior 174 legislation appeared to allow for reductions only if the R&D credit exceeded the current year’s deduction.

The bill is currently stalled in the Senate with hopes of a resolution this year. To ensure you maximize software development costs available under Section 174, JLK Rosenberger has highlighted interim guidance issued in Notice 2023-63 and Notice 2024-12 below. In addition, if the extenders bill does not pass, there were some accounting method changes to comply with the amortization requirement specified in the updated interim guidance issued in January of this year.

Rev. Proc. 2024-9 specified accounting method changes that allowed for reliance on interim 174 guidance in Notice 2023-63 for automatic consent for year one. It also addresses long-term contract SRE costs under Section 460 to allow for accounting method changes to be made on the same or a modified cut-off basis. For the first taxable year post-December 31, 2021, taxpayers could include a statement with their originally filed return to change their accounting method to comply with 174 automatically. For accounting method changes two years after December 31, 2021, taxpayers must file Form 3115, reference the applicable DCN for the method change, and include a declaration stating the reason for the change. Taxpayers must report a modified adjustment under Section 481(a) if a positive amount results from the change. If the change leads to a negative amount, taxpayers can report it on a cut-off basis.

The guidance also provided much-needed clarity on what types of costs can be included under Section 174. First, eligible specified research expenditures (SREs) can be included in the deduction. SREs are defined as “any pilot model, process, formula, invention, technique, patent, computer software, or similar property (or a component thereof) that is subject to protection under applicable domestic or foreign law.”

In addition, activities that began after December 31, 2021, related to developing a new or improved software SRE product can be included. These include new software development activities or those geared towards adding new functionalities or improvements that materially increase the efficiency or speed of existing software. All software product development, such as system, program, application, embedded, or software storage in all media forms, are included.

Individuals performing SRE activities or directly supporting software development can be included. Some SRE activities related to software development include designing the software, building a software model, writing or converting source code, testing the software, and developing improvements. If software is developed for sale or licensed to outside parties, then costs to produce the masters can also be included.

General administrative or payroll services, interest on debt to finance SRE development, routine quality control or inspections, efficiency or management studies, consumer marketing surveys, and literary, historical or research in similar fields are excluded. Also excluded are costs to acquire someone else’s patent or SRE product and certain website costs, such as maintenance, hosting fees, domain registration, trademark fees, and maintenance activities.

Certain software development activities are excluded from Section 174 costs. These include database or information bases (i.e., customer/business lists, files, books, records, etc.), software installation costs, training employees or others to use the software, data conversion activities to translate the data into a different format for system compatibility, costs that relate to activities that took place after development or when the software is placed in service or is ready to market to others, and other post-development activities, such as maintenance, bug fixes, and marketing.

The interim guidance also provided examples of the types of expenses that can be included, such as labor costs for employees or contractors performing activities related to the development of a SRE product, including wages and other compensation, such as stock-based, vacation & sick pay, payroll tax, and similar costs. Fees paid to outside contracted parties if the taxpayer has Rights and Financial Risk in the SRE product being developed can be included. Financial Risk is determined by the party who bears the cost if the SRE product fails or cannot be developed. Rights to the SRE are determined by who has the rights to use or exploit the SRE product developed under the contract. Materials and supplies directly related to SRE product development that are not depreciable under Sec. 168 can be included, as well as certain cost recovery allowances (i.e., depreciation, amortization, depletion) for property used to perform activities to develop the SRE product, as well as patent costs and certain operation and management expenses, such as rent, utilities, insurance taxes, repairs and maintenance, and travel expenses. It is important to note that the cost must reasonably relate to the development of the SRE product, and you must be consistent with allocation methods used to calculate costs and the types of SRE expenses included from year to year.

R&D Tax Credit Benefit

The Federal R&D credit is available to companies of all types and sizes annually, which yields an immediate reduction in taxes owed. It is also available as a refund claim up to 3 years back, and any unused credits can carry forward for 20 years. Most recently, the Inflation Reduction Act significantly expanded the tax savings opportunity to use the credits to offset current payroll tax owed for many start-up companies or businesses within the first 5 years of operations. Starting in 2023, the maximum credit amount that can be claimed against a qualified start-up company’s payroll tax liability doubles from $250,000 to $500,000 per year.

Qualifying software activities for insurance companies don’t need to involve a major technological advancement, a substantial budget, and expenses; they don’t even need to succeed. This is especially true as the industry moves towards greater technology integration to streamline traditional business processes (i.e., claims management, risk assessment, etc.). Eligible software activities we commonly see for insurance businesses generally interface with third-party applications as opposed to those used primarily for internal purposes, such as general administrative or human resource functions only. Development efforts should focus on designing, coding, and testing for new and improved products or functionalities. This means investment in custom software development that integrates claims management, policy compliance, quoting, and risk analysis functions with third-party applications will likely qualify as these activities only need to pass the Four-Part Test under the Tax Code in Section 41(d). Software development projects likely qualify for the R&D credit, so it is important to understand which expenses can be taken towards the credit calculation.

Typically, this includes a mix of expenses paid to employees performing R&D activities and contractors used in conjunction with these activities. In particular, employee wages, outside contracts (65% of costs if paid on TM or hourly basis), cloud computing fees related to development, and certain materials for integrated software/hardware can often be included. This can include using a cloud-based environment for development work or designing and using a mirrored virtual environment to test new coding configurations. Of course, there may be other qualifying expenses, but those need to be identified on a case-by-case basis. All activities must also be performed in the United States to qualify.

Here is an example of what this could mean in tax savings for your company. Suppose a company has $1,000,000 in contractor developer costs and $1,000,000 in total payroll, where employees spend 25% of their time on software development. This translates to $650,000 in contractor developer costs and $250,000 in employee costs, totaling $900,000 in R&D expenses. Depending on current tax rates, this could translate into a federal credit benefit ranging between $64,000 to $72,000 in federal tax savings. In addition to the federal benefit, many states offer a version of the R&D credit that can potentially reduce business and individual taxes owed.

The opportunity to once again expense eligible R&D costs in the year incurred is welcome news for many companies. Unfortunately, the bill is still working its way through the Senate and will require additional time before passage. We will keep you updated on any changes.