R&D Credit Rules for Internal Use Software Finalized

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.

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.