Posted by Jeffrey Feingold on 10.11.16
The IRS has issued final rules that clarify whether software that a company develops for its own internal use can qualify for the research and development (R&D) tax credit. In issuing its final regulations, the IRS also addressed the issue of whether software that a company develops for use by other companies can qualify for the tax credit. For the most part, the IRS adopted the proposed changes it issued in January 2015, with one significant change.
Internal-use software generally refers to software that has been acquired, internally developed or modified exclusively to meet a business’ internal needs. For many years, there has been little tax guidance as to whether internal use software is eligible for the research tax credit. In fact, the original rules date back to the pre-internet era.
In examining whether internal-use software should qualify for the R&D tax credit, the IRS proposed regulations last year that allow for the inclusion of software that is developed by the taxpayer for internal use, if that software is used for general and administrative functions that “facilitate or support” the taxpayer’s trade or business. The proposed regulations indicated that software is not considered internal use when it is being commercially sold, leased or marketed to a third party, or if is being developed to enable the third party to initiate functions or review data on the taxpayer’s system.
In its final rules, the IRS adopted proposed regulations that confirm that software developed for the entity’s internal use for the purpose of general and administrative functions is limited to:
The adopted regulations allow a taxpayer to meet a high-threshold-of-innovation test that allows otherwise excluded internal-use software development to be considered qualified research. Software needs to pass an innovation test, be commercially unavailable and involve significant economic risk.
While the final rules were issued with just a few modifications from the proposed regulations issued last January, there was one substantial change. While the proposed regulations would have eliminated appropriateness of design for the purposes of the process of experimentation for internal-use software, the IRS took note of many comments it received about the difficulty of distinguishing between the closely linked method capability and design uncertainty. As a result, the IRS restored appropriateness of design as an uncertainty for internal-use software.
It should also be noted that companies that develop software for other companies can still qualify for the R&D tax credit. The original rules were written before the internet, so some businesses are developing software that doesn’t fall under the sale, lease or license exclusion, yet it is also not considered general administrative software. The IRS provided a safe harbor for third-party-facing software that customers can access online to transact business with a company, such as viewing records or data.
The IRS is providing some leeway for taxpayers who relied on the regulation proposed last January. Therefore, taxpayers can go back to taxable years ending on or after January 2015 and decide whether to apply the proposed or final regulations. According to the Federal Register, the final regulations will be effective on Oct. 4, 2016.
Your accountant or qualified R&D tax credit expert can help you determine whether your business activities meet the criteria of the test by conducting a tax credit study.
The R&D tax credit can be a lucrative incentive for innovative businesses. Given the new permanent nature of the tax credit, now is the time to consider whether activities performed by your company qualify for major cash-saving tax credit opportunities. To learn more about whether your industry and company activities meet the R&D four-part test, request our free assessment today.
Tax Point Advisors, a firm with expertise in working with small and midsize companies, works with businesses that may qualify for R&D tax benefits. For more information, please leave us a message below.