Alternative Investment

R&D Credits for Alternative Investments

Many AI companies are engaging in custom software development for a variety of purposes. This development can be leveraged into significant tax credits, with the right help! Jon Sharon, AI Tax Partner at Richey May, sits down with the team at Source Advisors to talk about how these credits can benefit AI leaders get more out of the development they’re already doing. Contact us to learn more and see the full transcript below.

Jon: Hi everyone and welcome. My name is Jon Sharon. I’m a tax partner at Richey May. Today we’re going to be talking about R&D credits with the Source Advisors team. Here with me the team and I’ll introduce you to Dave who’s going to introduce his team.

Dave: Thanks Jon. I’m Dave Finley. I’m the Director of Business Development for the Midwest for Source Advisors and a CPA by trade, but thankfully I don’t do much of that these days. I’m more the client the liaison between our firm and our CPA firm Partners like Richey May and their end client. So that’s my job is to help bring our resources to bear to quantify opportunities and present them to clients. With me today is Louis Riley who heads up our Financial Services Group. He is the international director of financial services and quite a lot of experience in the fintech industry. About 10 years ago, he realized the opportunity to bring R&D credits to what what is going on in the fintech industry. That’s his his strong suit. And then lastly with us is Moi Romero and Moi is the senior director of our controversy group and besides having close to 20 years of technical experience directly in R&D, he heads up our controversy group. And so any time there’s an audit of an R&D credit the buck stops with Moi, so he’s got a wealth of experience in a couple of different areas there. So that’s us!

Jon: Perfect, thank you, Dave, so today we’re going to talk about how the R&D credits can specifically affect the alternative investment industry and what that might mean if you are in that industry, so I guess it started off. Louis, tell us a little bit more about the R&D credits.

Louis: Sure, IRC 41 the credit for increasing research activities, has been around since 1981, but it was made permanent a few years ago. So it’s a permanent annual benefit and the cash tax savings can range from 5 to 10% of the amount of money that companies spend on research and development. In fintech, research and development generally means software development. So there’s a lot of that going on in the fintech industry moreso now than ever our clients range from some of the world’s largest hedge funds to startups, banks other kinds of alternative investment companies. Any company that has developers on staff is probably doing R&D. The credit can be used to offset corporate tax or as we more commonly see in this industry. They flow through to the members or the partners of the firm and the credits can be substantial. We’ve qualified credits from some of the largest ones the United States from multi-million dollars again down to payroll tax credits for startups. So it’s a bit you’re doing the work already if you’re coding and you should definitely avail yourself of this opportunity from the government as well as from several States in the United States, which have a methodology that piggybacks the Federal Credit. The input to the credit, the main component is wages, but also payments to contractors qualify as do a cloud computing costs. In the financial services industry. The biggest credits obviously come from the companies that have the biggest software development efforts. So that’s usually quant with teams of developers that are writing proprietary code. Bonuses also qualify and so of course in fintech and hedge fund that’s a significant portion of compensation. So that’s how the credits can get pretty big. Traders these days or you know, usually coders, and the people
that supervise the coder, the programmers and coders that are doing the work, and the people that support them, a portion
of their wages also qualify for the credit.

Jon: Excellent. So, what type of funds, you mentioned in a little bit with traders and others, but what type of funds should really be looking at this for themselves to see if they qualify?

Louis: I’m going to let Moi get into this in greater detail, but definitely Quant. I mean, if you’re doing anything involving quantitative research, machine l earning, artificial intelligence, is a slam dunk and you’re doing R&D. Discretionary funds, I’m going to let Moi speak to that.

Moi: Yes, so as Louis said the credits really for proprietary software development, right? So, the word R&D is a little bit of a misnomer but it’s really for proprietary software development. Just purchasing software off-the-shelf doesn’t qualify. There is an exception if you significantly modify third-party software and integrate that into your environment, that could potentially qualify. Also, there are some firms these days doing some hardware development. Of course, they’re not building the hardware from the ground up, but they are in many cases optimizing that hardware, so oftentimes are working with the vendor to build custom hardware. This could be things like FPGAs, GPUs even things as simple as network switches and data cards, but you know you doing these kind of custom developments within hardware to optimize them, generally for late for latency, the “need for speed” right, but it is mostly for software. So I kind of see three core areas where the majority of software development is done and we qualify. One area is what I would call trade execution, and this is where you know, basically anything that’s needed to carry out the trades right the systems that actually carry out the trades or kind of facing outside world. This could include your trading platforms, order management, pricing engines and you know outside connectivities. This can be connectivity to exchanges, third-party market data providers, and anything that actually executes the trades. The second area would be you know, really more around quantitative trading firms and they really need to have a separate research infrastructure that is separate from their production environment. I’m so this is going to be for typically for quantitative traders where they’re essentially looking for alpha right profitability and forecasting trades, all the data analysis how they actually simulate what’s happening in the market around development and then ultimately developing the actual trading strategies. And then a third area that’s really going to be common for really almost all taxpayers in this space I think the question is going to be where they actually buy this software where they develop it, you know in house, but it’s going to be software that’s used to run the business. So oftentimes, you know, they have a need for real time information in this space, but it’s for software that you use more of a back office function things like P&L management, full-time analysis, real-time risk management, portfolio tracking and even things as simple as compliance and reporting. So broadly I see those three core areas of fulfillment that would qualify in this industry.

Jon: Are there any other specific areas where people may not know that, “Hey I qualify for the credit for doing this type of activity or that type of activity?”

Moi: So I think it’s in that third bucket that I mentioned, it’s good question, that third bucket of run the business software, if you will, kind of the back office functions software. Everybody has that right? Again, the question is are they buying them or are they significantly customizing it at least, or better yet, is it proprietary? So sure you can buy a lot of these things commercially, however, against the real-time needs for this industry often doesn’t lend itself to just purchasing something right off the shelf, so in many cases they’re significant modification needed. But I would say more importantly is one of the things that Louis had mentioned it’s not just the developer time, right? If you’ve only got two or three developers that are doing this kind of activity then it’s probably not going to rise to the level of enough material enough to really claim the credit but typically the operational people, the business people, are the ones actually providing the requirements to the developers so it could be a trader, it could be somebody working in the back office, even an accountant, who’s providing those requirements, you know to the developers, and then in conjunction with that are doing testing on the initial versions of the software. So it’s really an end-to-end kind of thing. You really need to look at it from a development life cycle standpoint, and anybody who’s involved. So if it was only the developers, maybe it wouldn’t make sense, but when you start adding some traders that are typically more highly compensated, then business people that are involved it adds up pretty quickly.

Jon: Yeah sounds like there’s a lot of opportunity out there and a lot of people may not even know that what they’re doing qualifies. Maybe a couple of examples of some funds that you’ve worked with that have qualified for the credit?

Moi: Yeah, so I think a good example is, let’s give a couple of hedge fund examples. So, we work with a we have for a number of years, about a five billion dollar hedge fund. When we first started talking to them, you know, they knew they had some development but it was kind of the lower level stuff that I have been talking about and they hadn’t really consider their back office functions and really consider their traders and their business people that are involved in providing the requirements and the specs for the software. And so the first year, which I think was to 2017, their credit was only about a hundred and fifty thousand dollars, purely based on wages. And then now it’s more than tripled. With not a lot more head count, a lot of that has driven by trader compensation, but they’re involved in this software development. So, now they have about a four hundred fifty thousand dollar credit per year. I mean it’s you know, a lot of it is quantitative driven. They do have the modeling and analytical type of work and some automatic forecasting, and things like that, but a lot of the software is asset, you know class-specific libraries and then some of the back office software that we talked about. Then another example would probably be also another hedge fund client, and this is really using a data science approach to discretionary trading. We’ve talked a lot about quantitative trading, but a lot of discretionary traders are now using the same concepts of big data that the quantitative trading firms are doing. So they call it “quantumental” trading, is kind of the buzz word, but it’s basically using, you know, vast amounts of data that a human cannot handle, so you’ve got to develop programs and tools to not only intake that data from your market data provider, but then how do you sympathize that data? How do you manipulate that data? And then present it and distribute it to your traders in a way that they can understand. And so that’s a big area. We had a client that only had about five data scientists, so if you only took the compensation of those five data scientists, it probably would not be a significant enough credit for them. But then when you start considering, okay, you got you have the highly compensated traders that are providing specs to them, you know the same that we talked about before, and trader compensation is much more significant, so even if you’re adding, you know, 10-15 percent of a traders time based on their compensation, that can be significant. So that credit only based on the data scientists would have probably been about a 50,000 dollar annual credit. But adding in the trader comp made it about $150,000 annual benefit. On an annual basis. it’s pretty significant for them.

Jon: Yeah, definitely. And so to that note, what else should fund managers be aware of from a tax perspective, whether it’s related to the credit or taking the credit what other type of information?

Moi: Yeah, so a question from a tax perspective, it’s actually, you know, not that complicated since it is a credit, right, below the line, but there is one limitation with the credit and that’s for Alternative Minimum Tax, you know, all CPAs know what Alternative Minimum Tax is, but with respect to this industry, to the extent that a taxpayer either at the corporate level or at the individual level is an AMT, Unfortunately, you cannot offset the credit, offset AMT with the credit. There is an exception for that for small companies which are less than 50 million in gross receipts for the prior three years. So if you are less than 50 million in gross receipts, then you can use the credit against AMT. So that’s really the only limitation there is, one actually though nice special exception for small companies to monetize the credit if they’re actually, you know, not not paying income tax. It’s for specifically for startups and it’s called actually a qualified small business or a QSB and to the extent you qualify as a QSB, you can actually use the credit against payroll tax. As you know, most startups are in losses for their first years couple years or several years, so it’s an opportunity to use that that credit and so a QSB is defined as any company with five or less years of revenues and less than 5 million of revenue in the current year. And then if you meet that two-pronged test you can actually convert that credit into a payroll tax credit and monetize it immediately.

Jon: Thank you guys again for your time today and please do reach out. If anybody has any questions who’s viewing this reach out to the Richey May team. We can get you introduced to Dave and his team or feel free to reach out to them directly and we’ll coordinate with them on that. Thank you everybody for your time.