R&D Tax Credits for Internal Use Software

R&D Tax Credits for Internal Use Software

Posted by on 08.16.19

In 2016, the IRS issued final regulations providing rules for taxpayers who develop their own internal use software and want to claim the R&D (research and development) tax credit. For many years, there has been little tax guidance as to whether internal use software (IUS) is eligible for the research tax credit. In fact, the original rules dated back to the pre-internet era. Internal use software generally refers to software that has been acquired, internally developed or modified exclusively to meet a business’ internal needs. These regulations help clear up the confusion that has long reigned over what is truly considered internal use software development, as opposed to software developed with the intent to sell, lease or license it.

R&D Tax Credit

The R&D Tax Credit is a federal tax incentive designed to promote businesses that incur costs for technical work within the United States. The incentive allows businesses of all sizes, not just major corporations, to receive a tax credit for qualified expenses incurred for research and development. Introduced in 1981 to create jobs and spur technology in the United States, the R&D tax credit has been modified over the years to apply to a host of businesses in industries including manufacturing, construction, engineering and software development. In 2015, the R&D tax credit was made permanent by the U.S. Congress and is now a dollar-for-dollar benefit against tax that qualified American companies can depend on.  Eligible costs include employee wages, cost of supplies, cost of testing and contract research expenses. Given the high amount of R&D work required designing and developing software, companies involved in technology and software development are generally some of the better candidates for claiming the credit, with many of their everyday projects tying directly to eligibility.

The Rules

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:

  1. Financial management – record keeping such as accounting, inventory management, budgeting and forecasting, financial reporting and tax
  2. Human resource management – hiring and training employees, payroll and benefits
  3. Support services – data processing, facility management, marketing and security services

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. Internal use software needs to pass an innovation test. The determination of whether these standards are met will vary for each taxpayer.

The Innovation test:

  • There must be an economically significant reduction in cost or improvement in speed or other measurable improvement that is targeted by the project
  • The software must not be commercially available
  • There must be significant economic and technical risk that makes the recovery of the resources devoted to the project uncertain

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.

Thanks to these updated regulations, non-traditional software companies that are investing time and efforts into the development of internal use software to build and streamline their business functions, can expect to receive a substantial boost in their ability to claim R&D based tax incentives.

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 provides R&D tax credit study services and other specialty tax services to CPA firms and their clients throughout the U.S. To learn more about R&D tax credits from the experts at Tax Point Advisors, please call us at (800) 260-4138 or please leave us a message below.

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