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R&D Credit Rules for Internal Use Software Finalized

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New Rules Represent Significant Easing of Requirements on Businesses That Would Like to Claim the R&D Credit

Regulations finalized by the IRS on October 3 suggest that the costs a business incurs to develop software for internal use may be more likely to qualify for the Research and Development (R&D) Tax Credit than many taxpayers previously understood.

Internal use software (IUS) has always been held to a higher standard than other types of research when it comes to qualifying for the R&D credit. But the new IRS guidance clearly suggests some software development costs that were previously thought to be IUS were in fact likely to be exempt, and the new guidance also eases some requirements on IUS software when it comes to qualifying for the credit.

The new rules don’t change the four criteria that qualify an activity for the R&D Credit:

  • It must be intended to discover information that would eliminate uncertainty concerning the development, improvement, or design of a product or business component.
  • It must be undertaken to discover information that is technological in nature.
  • The intended result must be useful in the development of a new or improved business component.
  • Substantially all of the activities must relate to a process of experimentation.

Once an activity meets these criteria, IUS must meet three additional criteria—referred to as the high threshold of innovation test—to qualify for the credit:

  • The activity must involve significant economic risk.
  • It must meet a high threshold of innovation.
  • No comparable third-party software is available for purchase.

The concept of IUS, because of the final regulations, is going to largely be restricted to general administrative functions, such as:

  • Financial management
  • Human resources management
  • General day-to-day support services of your company

Clarification of the 3-Point Criteria

The IRS has made it easier and less controversial to comply with the three additional criteria above that IUS must meet to qualify for the credit. For instance, the IRS concluded that the high threshold of innovation doesn’t require that you make a revolutionary discovery or that the software development be successful.

The IUS development involves “significant economic risk” if you commit substantial resources and there is substantial uncertainty, because of technical risks, that you might recover those resources within a reasonable period. “High threshold of innovation” is defined as resulting in a reduction of costs or an increase in speed, either of which are substantial or economically significant.

The new rules, which are largely consistent with the proposed regulations, clarify that some types of internally developed software are not IUS. For example, software you might have developed to interact with third parties or to enable third parties to initiate functions or review data on your business’ systems do not need to meet the additional IUS criteria to qualify for the R&D credit. The determination of whether the software was developed for third party use is based in large part on the intention of the company at the start of the software development effort.

Examples of software that may not qualify as IUS include:

  • Bank transaction software
  • Software apps for a mobile device
  • Software developed by a manufacturer to enable its customers to order products online

Furthermore, software developed to be sold, leased, or licensed is generally not treated as software developed primarily for internal use.

On the whole, these new rules represent a significant easing of requirements on businesses that would like to claim the R&D credit for software that they develop themselves or pay outside contractors to develop. If your business incurs costs for software development, this is a great time to take a closer look at those costs in light of the new rules to find out if you may be eligible for additional credits.

R&D Tax Credit Assessment - Freed Maxick

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R&D Credit Rules for Internal Use Software Clarified

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IRS proposed regs indicate that more costs may qualify for the credit than many people realized.

Rules proposed by the IRS suggest that costs a business incurs to develop software for internal use might be more likely to qualify for the Research and Development Credit than many taxpayers had previously understood. Internal use software (IUS) has always been held to a higher standard when it comes to qualifying for the R&D credit. The IRS guidance clearly suggests some software development costs that were previously thought to be IUS were in fact likely to be exempt, and it eases some requirements on software that is IUS when it comes to qualifying for the credit.

The new rules don’t change the four criteria that qualify an activity for the R&D credit:

  • It must be intended to discover information that would eliminate uncertainty concerning the development, improvement, or design of a product or business component.
  • It must be undertaken to discover information that is technological in nature.
  • The intended result must be useful in the development of a new or improved business component.
  • Substantially all of the activities must relate to a process of experimentation.

Once an activity meets these criteria, the business needs to determine if the activity relates to IUS. If it does, it must meet three additional criteria to qualify for the credit:

  • The activity must involve significant economic risk.
  • It must meet a high threshold of innovation.
  • No comparable third-party software is available for purchase.

Non-Internal Use Software

On one hand, the new rules clarify that some types of internally developed software are not IUS. Software that is developed to interact with third parties or to enable third parties to initiate functions or review data on a business’ systems likely no longer need to meet the additional criteria to qualify for the R&D credit. Examples of software that no longer needs to meet the three-part IUS test include bank transaction software, delivery tracking sites, and programs that allow a customer to search a business’ inventory.

Lowering the Bar for IUS

On the other hand, the IRS made it easier to comply with the three criteria that IUS must meet in order to qualify for the credit. The new rules allow that IUS meets the innovation test if the development “is or would have been successful,” a significant relaxation on the previous requirement that the development must be successful in order to meet the innovation standard.

R&D Credit for Manufacturers - Buffalo CPA On the whole, these new rules represent a significant easing of requirements on businesses that would like to claim the R&D credit for software that they develop themselves or pay outside contractors to develop. If your business incurs costs for software development, this is a great time to take a closer look at those costs in light of the new rules to find out if you may be eligible for additional credits.

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New Opportunities for the Research and Development Tax Credit


R&D Tax Credits - Buffalo Rochester NYIn 2015, two new sets of published tax rules provided several favorable developments for U.S. taxpayers claiming the research and development (R&D) credits. Many taxpayers, including for example those who developed software interface for third parties to engage in business through the internet, could benefit from these rules.

Proposed treasury regulations, released on January 16, 2015, clarified the types of activities for developing internal use software (IUS) that are eligible for the credit. In addition, the “Protecting Americans from Tax Hikes” Act (PATH Act) enacted on December 18, 2015 established laws that promoted the ability of most taxpayers, including start-up businesses, to claim the credit.

Under the PATH Act, the following provisions were enacted into law:

  • The Credit is Now Permanent. The R&D credit, which had expired for amounts paid or incurred after December 31, 2014, was retroactively reinstated and made permanent. Fiscal year taxpayers whose tax year ended in 2015 might want to file amended returns to claim the credit for amounts paid or incurred on or after January 1, 2015, and before the end of their fiscal year.

  • Certain Small Businesses Can Use the Credit to Offset Alternative Minimum Tax. Beginning with the 2016 tax year, eligible small businesses (ESB) and their owners can claim the R&D credit against the alternative minimum tax liability. An ESB includes partnerships, sole proprietorships, and privately held corporations whose average annual gross receipts for the three-tax-year period preceding the tax year for claiming the credit does not exceed $50 million.

    R&D credits determined for a partnership or S corporation are not treated as ESB R&D credits by any partner or shareholder unless that partner or shareholder also meets the gross receipts test for the tax year in which the credits are claimed.

  • Certain Small Businesses Can Use the Credit to Offset Payroll Tax. Beginning with the 2016 tax year, a qualified small business (QSB) can elect to use the R&D credit against the employer’s old-age, survivors and disability insurance liability (i.e., FICA taxes). The election can be made for up to five tax years.

    The R&D credit is allowed to offset payroll taxes for the first calendar quarter which begins after the date on which the taxpayer files their tax return with the election. A QSB doesn’t include tax exempt organizations.

    Generally, the portion of the credit eligible to offset payroll tax is limited to the lesser of $250,000, the current year credit, or for regular corporations, the amount of the credit carryforward from the tax year determined without regard to the election.

    The credit does not reduce the amount of the FICA payroll expenditure otherwise allowed as a deduction.

    Generally, a QSB is a company that has less than $5 million in gross receipts for the current tax year and no gross receipts for any tax year before the five tax year period ending with the current tax year.

The proposed regulations on internal use software included the following guidance:

  • IRS Noted the Increasing Importance of Computer Software for Businesses. The government explicitly narrowed the application of the IUS rules to general and administrative (backroom) functions. Activities associated with IUS have a much higher threshold and by limiting their application this effectively expanded the software activities eligible for the credit.

  • Website Design Costs. Many businesses develop websites to interface with third parties which may qualify for the credit. The IRS acknowledged that certain of these costs were never subject to the much more narrow IUS rules. As a result, taxpayers may have an opportunity to claim more credit. They should review their web design/third party interface costs for prior open years and file amended returns if they determine these costs were eligible for credit under the standard, less restrictive R&D credit rules.

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