Tax Beat: Digital Transformation and R&D Tax Credits

HOST: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters.

BROOKS NELSON: Welcome to the Cherry Bekaert Tax Beat podcast. Today we're looking at the R&D federal tax credit and how it can help finance digital transformation. Companies transforming business practices and tools to the 21st century using data and technology can benefit from identifying activities that could qualify for these tax credits.

BROOKS NELSON: Joining the discussion are my colleagues from CB Digital and our Strategic Tax Advisory Services: Nita.

NITA SANGER: Hi, this is Nita Sanger. I'm a director in our Digital Advisory Services and I focus on business transformation and innovation.

BROOKS NELSON: Where do you sit, Nita?

NITA SANGER: I sit out of the Tysons Corner office.

BROOKS NELSON: Awesome. And Dan.

DAN MINNELL: Hi, thanks, Brooks. My name is Dan Minnell. I'm a partner in our Strategic Tax group, specifically within Cash Recovery Services, and I focus primarily on R&D incentives. I'm located in San Jose.

BROOKS NELSON: All right. He's got a warmer temperature than probably the rest of us today.

SARAH MCGREGOR: Speak for yourself. Down here in Greenville, South Carolina, it's kind of toasty today.

BROOKS NELSON: I'm Brooks Nelson. I'm a tax partner and I sit in Richmond, Virginia. Sarah, how's life treating you?

SARAH MCGREGOR: Life is good. Today we're getting into the midseason football season and I am very excited about that.

BROOKS NELSON: Who's playing?

SARAH MCGREGOR: Tonight it's the Cowboys.

BROOKS NELSON: All right. Let's get back to the topic at hand. We have two big-picture topics and we're going to talk about how they intersect. First, the R&D tax credit. It's been around since 1981 and was enacted to encourage investment and innovation in U.S. technology. It has bipartisan support and remains a valuable tax credit.

BROOKS NELSON: Second, the relevance of this credit to digital transformation. According to McKinsey Digital, only about 8% of companies believe their current business models will remain viable if they don't digitize. Shifting to digital requires not only upgrading IT and tech infrastructure but transforming your entire business model. We'll talk with Nita about digital transformation and then pair Nita and Dan to discuss how the R&D credit fits into that work.

BROOKS NELSON: Nita, how do you define digital transformation?

NITA SANGER: Digital transformation is transforming your entire business model — how you go to market, the products and services you offer, and how you run your operations — leveraging technology and data as the core of your competitive advantage.

SARAH MCGREGOR: Nita, what are the top three hurdles to transform an entire company?

NITA SANGER: The first hurdle is recognizing the need for digital transformation. People are often reluctant to change, and acknowledging there's a need to do something different is critical.

NITA SANGER: The second hurdle is recognizing the role of people. Digital transformation is not about technology alone; technology is the enabler. Customers' needs are changing, and employees closest to the customer will identify pain points and use the tools and solutions. You must consider customers and employees together.

NITA SANGER: The third hurdle is executing the transformation. Historically, about 15% of digital transformations are successful, even in tech-savvy industries. Successful transformations require leadership sponsorship, ideally from the CEO, the right skills — not just the existing staff repurposed — and a commitment of time and investment.

SARAH MCGREGOR: Dan, Nita mentioned technology as an enabler. Let's talk about R&D fundamentals and where these worlds intersect.

DAN MINNELL: I think of it as a Venn diagram. The IRS rules for R&D differ from common perceptions. There is a four-part test: the activity must be a new or improved product or process, have a technological nature, involve specific uncertainty, and include a process of experimentation. The uncertainty and experimentation requirements are key.

DAN MINNELL: Qualifying activities often include employees testing concepts or specifications and modeling to resolve technical issues. The main cost components we evaluate are wages, supplies (less common in these cases), and third-party contractors, which often apply when work is outsourced.

SARAH MCGREGOR: We usually think of R&D as product development, but here we're considering processes and new techniques to operate the business.

DAN MINNELL: Correct. With SaaS and cloud-based applications, what used to be purchased platforms are often operated in the cloud. Consider whether software is being implemented or developed internally, and look for pockets of R&D in those areas.

SARAH MCGREGOR: What are areas of uncertainty in digital transformation projects?

DAN MINNELL: Company-specific IT projects are a common example: developing software that isn't commercially available or implementing systems like ERP or CRM. These are not purely off-the-shelf implementations because each company is unique, with legacy systems and integration work. Custom code and integration often create the uncertainty and experimentation needed for R&D qualification.

SARAH MCGREGOR: So you don't know if it will work until you try it.

DAN MINNELL: That's right. Many aspects of IT development are facts- and circumstances-driven. Implementations can take longer because unknowns arise during the process. That uncertainty and experimentation are what you must track.

NITA SANGER: Creating new products and services is also experimentation. Before rolling anything out, you decide what technologies to use, customize off-the-shelf solutions, and test them. You bring in users, providers, and your technology to iterate. That process generates a lot of experimentation.

SARAH MCGREGOR: The IRS has addressed ERP system implementations and noted that some elements are eligible and others are not.

DAN MINNELL: Correct. The IRS guidance is not binary; it provides examples. You must match a client's facts to those examples and draw reasonable inferences. ERP guidance contains specific examples but does not cover every IT development scenario, so understand the facts and overlay them onto IRS examples.

BROOKS NELSON: Dan, can you give a broad numerical example of how much an R&D credit might be worth?

DAN MINNELL: Broadly, combining federal and state incentives, the benefit is typically seven to ten cents on the dollar. State incentives vary, but seven to ten cents per dollar spent is a useful rule of thumb. Attributes can be carried forward, so credits you can't use today because of a loss may be usable in the future.

SARAH MCGREGOR: You still get a deduction for the expenditures now or later.

DAN MINNELL: Yes. Also consider that software and ERP components may be deductible now or capitalized and amortized over years. That impacts ROI, so involve a tax expert early to assess timing of deductions and credits.

BROOKS NELSON: Nita, how would you describe your role in a digital transformation project?

NITA SANGER: Our role varies by project stage. We do not own the transformation; the C-suite must own it. At the start, we act as a guide: explaining market dynamics, competitor activity, new technologies, and how those affect the client. We assess the client's products, services, go-to-market approach, and operations, then create a roadmap with focus areas, estimated costs, and steps to get there.

NITA SANGER: Once a client decides on a path, we act as orchestrator, bringing together the needed resources and sequencing the work. After implementation, we help with ongoing adjustments because change is continuous. We can also provide fractional talent or other managed services after the transformation.

BROOKS NELSON: What is a typical timeline for a digital transformation project?

NITA SANGER: The guide phase can vary from three to 12 weeks, depending on complexity, to develop the roadmap. Execution of the roadmap is longer, typically 12 to 36 months, because you'll build minimum viable products, experiment, iterate, and roll out multiple initiatives in parallel. You should pursue enough early work to get quick wins while committing to a long-term timeline.

BROOKS NELSON: Dan, given that timeline, when should companies pursue the R&D credit? Do they wait until everything's done?

DAN MINNELL: No, you shouldn't wait until everything's done. Projects often span multiple years, but tax filings are annual. Ideally, evaluate R&D annually and be proactive. If working with third parties on custom software, establish tracking and bifurcation of eligible versus non-eligible tasks and obtain invoices with adequate detail to support the credit.

SARAH MCGREGOR: Do your services help bring in other professionals — coders, system integrators, and outside consultants — needed for implementation?

NITA SANGER: Absolutely. We focus on advisory and project management, but we also bring in specialists for experimentation, design thinking, technology solutions, integrators, and change management experts. We help vet and select the right partners and can identify managed service providers for outsourced processes or risk management.

BROOKS NELSON: Dan, describe the importance of tax involvement up front for R&D credits.

DAN MINNELL: Getting involved early helps us define the business component and understand the product development process end to end. Early involvement allows us to identify the intended investment, the parties involved, and the documentation needed. That avoids having to chase third parties for details later. Understanding the lifecycle and intended solution helps you match facts to IRS guidance, including ERP examples.

SARAH MCGREGOR: Identifying people is also important, since the credit is largely based on labor and wages.

DAN MINNELL: Yes. Ensure job descriptions align with roles involved in R&D. Job descriptions are key documents that support eligibility and can be helpful in an IRS audit. Facts should match documentation.

SARAH MCGREGOR: We work in a middle market environment. Who's a good candidate for digital transformation services?

NITA SANGER: Almost all our clients can benefit. Current market conditions favor middle market firms because larger firms often move slowly. Middle market companies can take strategic risks, gain market share, and expand their footprint. This is an opportunity to be nimble and get ahead of competitors.

SARAH MCGREGOR: Dan, who is a good typical client for the R&D credit?

DAN MINNELL: The R&D credit can apply to clients of all sizes and industries. Especially with digital transformation, many companies should be considering it. The key is being proactive and asking the right questions. Many companies miss credits that apply during digital transformations.

BROOKS NELSON: Sarah, any final thoughts?

SARAH MCGREGOR: This has been a great conversation. I'm getting a clearer picture of how digital transformation and R&D credits intersect and benefit each other.

BROOKS NELSON: Nita, any final comment?

NITA SANGER: I wouldn't have thought about the R&D tax credit in relation to digital transformation without this discussion. Recognizing that clients can benefit financially from R&D credits is valuable. When we work with clients, we should involve the R&D tax credit team to ensure they receive additional benefits.

BROOKS NELSON: Dan, any final comment?

DAN MINNELL: Use industry experience and IRS knowledge to identify helpful steps. Be proactive at the beginning and document what you can to support eligible R&D credits during a digital transformation.

BROOKS NELSON: I emphasize being proactive about both the R&D tax credit process and digital transformation planning. The transformation should drive what clients seek, and R&D credits can help finance and improve ROI.

BROOKS NELSON: This concludes today's podcast. We are not providing specific tax advice on this podcast. Please consult with your tax advisor, preferably at Cherry Bekaert, about your specific tax issues or to discuss information from today's podcast. Check the firm's website at cbh.com for the latest guidance materials on this and other tax and business topics.

BROOKS NELSON: Thank you, Nita. Thank you, Dan. Thank you, Sarah. And thank you to our listeners for spending your time with us. Please like, subscribe, and share. And let's call it a day and go forth in peace.