The R&D Tax Credit for Game Developers

Business Issues: Page (1) of 1 - 02/05/10

The R&D Tax Credit for Game Developers By Jason Mollner, J.D. and Robert Wonish, J.D.

For years, the video game development cycle has become increasingly difficult to sustain. Many software companies have begun to cope with the rising costs of developing games by outsourcing development, and with the current recession, this trend is continuing. In 1981, this country faced a similar economic downturn, and in order to counteract an increasing movement of jobs overseas, Congress enacted a federal tax credit designed to spur domestic investment in research and development.

Following the creation of the Research and Development (R&D) tax credit in 1981, federal lawmakers have continued to update, expand, and renew this incentive. In addition, most states have created an R&D tax credit of their own, making this incentive one of the most lucrative and effective tax saving vehicles available to the US video game industry. Recent court cases and legislative changes to the credit have helped make the R&D credit available to thousands of additional taxpayers, including video game developers, publishers, and studios.

One example is a software company, a client of ours that specializes in massively multiplayer online (MMO) games. This company, like most video game developers, employs teams of programmers to develop their graphics engine, to design their network infrastructure, to create development tools, and to develop the AI within the game. In addition, they employ a QA team, a dedicated build team, and design directors who supervise the development effort on each project. We examined this company's R&D projects undertaken in 2008 and identified more than $500,000 in federal and state tax savings for just a single year of their normal development process.

What is the R&D Tax Credit, and What Activities Qualify?

The R&D credit requires that software projects satisfy four basic requirements or tests to qualify:

1. You must develop new software for sale, lease, or license.
2. The work must be based in computer science, physics, or another hard science.
3. Some uncertainty must exist during development.
4. You must engage in a process of experimentation to overcome that uncertainty.

New or Improved Business Components
The R&D tax credit regulations require that any eligible software must be intended for sale, lease, or license, or be used in your trade or business. Successfully completing and releasing the software is not, however, a requirement. The effort must be to develop new functionality within the software or to improve the functionality, performance, or reliability of the software. For our client, not only did their game development satisfy this test, we were also able to recover some of their losses from work on a next-generation game engine that was ultimately scrapped.

Hard Sciences
This is one area of the law to which Congress has enacted major changes to assist software businesses. In the past, for a company to claim the R&D credit, it would have to be developing or discovering something that was new to the industry. The current regulations state that if taxpayers are relying upon existing principles of computer science in their development process, then they satisfy this test. Nearly all of the MMO developer's software development was based upon principles of computer science. However, some activities are excluded, including the artwork created for the characters and scenery in the game.

Uncertainty
So long as you have uncertainty of any one of the three following types, you will satisfy this test. The first type of uncertainty is whether it is possible to develop the new or improved piece of software as designed at the outset of development. The second is how to develop the software (such as the optimal method to manage memory within the code). The third and final type is uncertainty with respect to the appropriate design of the software (anything from refactoring a sorting algorithm to modifying the architecture of the graphics engine). In software, development uncertainty is almost everywhere you look; most game developers are already tracking many of these uncertainties in their bug trackers. For example, the MMO developer had significant uncertainty in resolving several thread contention and memory management issues during the development of its games. In addition, they invested months of work in order to conceptualize and design new AI pathfinding and aggro calculation routines.

Process of Experimentation
In order to eliminate the uncertainty you face, you must utilize your development process to systematically evaluate alternative solutions. Almost all software development is inherently a process of experimentation. The waterfall, agile, and scrum processes, as well as most other development processes, are built using the same pattern: develop an initial design and software architecture (a hypothesis), build out technical specifications and prototype code, test the code, evaluate the results of the tests to determining why the code didn't work, and then refactor the code to make it work.

The MMO developer had several ongoing projects, all of which followed variations of the scrum or the waterfall processes. Both of these development processes generally included steps that would satisfy this test. Both required designers and software architects to form initial designs that resulted in either user stories or other specifications, and both generally required several iterations of testing and refactoring the code prior to any release.

If You Think You May Qualify, How Do You Take These R&D Credits?
If you have run through the tests above and, like most software companies, want to take advantage of the most lucrative tax credit available to your industry, what do you do next? First, determine if your company is already claiming the credit. To do this, review your last federal tax return and look for a Form 6765. If you don't see Form 6765, then you need to talk to your tax advisors, whether that means your CPA, attorneys, or a specialty consulting firm.. Talk to them soon in order to ensure that you do not miss out on any benefit.

If you found a Form 6765 among the various forms on your tax return, your work still isn't done. The federal regulations that control the interpretation of the R&D credit have changed significantly in the past few years. As with most tax laws, court cases ultimately help clarify or instruct people on how to interpret the tax code. Recent and pending court cases have affected the R&D credit and could shift the rules related specifically to the software industry. If it has been a few years since you have spent some time with your CPA or advisor reviewing your research activities, it could pay to look again. In addition, you should check to make sure that you are also receiving any applicable state benefit for R&D. Taking the time to make sure you are claiming everything to which you are entitled is well worth the peace of mind that it will bring, to say nothing of the dollars!

Moreover, many companies capture software engineering activities that represent only a portion of the entire software development cycle that qualifies for the credit. This means that you may not be fully capturing the costs related to the video game design, project management, or all of the QA activities that occur within and outside your QA. We have frequently discovered development costs that are mistakenly not being allocated toward the credit, such as senior level individuals who regularly conduct smoke tests and acceptance tests but are otherwise not directly engaged in the programming of the game. We have also identified the opposite, where companies have taken credits that they were not permitted to take for a variety of reasons.

Conclusion
In our experience, game developers are typically excellent candidates for the R&D tax credit, but far too many are not taking full advantage of it. One of the reasons is that taking the credit requires the involvement of an expert with a strong background in both software engineering and tax law. In addition, understanding many of the complex licensing arrangements that exist between game companies who license graphics and physics engines requires an individual with specific experience in the game development industry. Due to the complexity of the statute and the challenges in understanding the complex issues encountered by software developers, few CPA firms have the right resources to fully advise their game-developer clients on the credit. For this reason, CPA firms typically recommend an outside consultant with this specific expertise.

Page: 1

Jason Mollner is an Associate at alliantgroup and a member of the firm's Software Industry Specialization Program. Jason holds a B.S. in Computer Science and a J.D. Robert Wonish is a Senior Associate in alliantgroup's Tax Controversy Services department. Robert holds a B.B.A. in Information Systems and International Business and a J.D.

Related Sites: Digital Producer , Audio Video Producer , Digital Game Developer , Oceania
Related Newsletter: DMN Newsletter , CMN Newsletter , Levels Newsletter , Digital Media Net , DMNForums

To Comment on This Article, Click HERE

Most Recent Reader Comments:

Re: The R&D Tax Credit for Game Developers by Tax Point Advisors at Mar. 04, 2010 4:56 am gmt

Re: The R&D Tax Credit for Game Developers by Peter Feldman at Mar. 10, 2010 8:12 pm gmt

Re: The R&D Tax Credit for Game Developers by Tax Point Advisors at Mar. 25, 2010 4:09 am gmt

The R&D Tax Credit for Game Developers by DMN Editorial at Feb. 06, 2010 12:03 am gmt

Click Here To Read All Posts
Must be Registered to Respond (Free Registration!!!, CLICK HERE)