IRS Issues Final Regulations for Internal Use Software and R&D Tax Credit: An Article Authored by Robert D’Andrea from KLR - Accounting Firm Boston, Massachusetts, Providence, Rhode Island

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IRS Issues Final Regulations for Internal Use Software and R&D Tax Credit

posted Oct 30, 2016 by Robert D’Andrea

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The IRS issued final regulations on October 4th which provide guidance on the qualification of Internal Use Software (IUS) for purposes of the Section 41 Credit for Increasing Research Activities. Essentially, companies are looking to understand if software that has been developed for their own internal use can qualify for the R&D credit. The final regulations address many of the comments received regarding the proposed regulations that were released in January of 2015.

What is Internal Use Software?

According to the IRS, Internal Use Software, or IUS, is software that is created by or for the taxpayer predominantly for use in general and administrative (G&A) functions that aid or support the taxpayer’s trade or business.

More about the Section 41 Credit

The Section 41, or Research and Development (R&D) tax credit, is a tax incentive for businesses to develop new (or improve existing) business components. By researching and developing new business tactics, businesses can create a significant reduction to their current and future federal and state tax liabilities.
The R&D credit is an actual dollar-for-dollar credit against taxes owed or taxes paid.

Four part test

There is a four part test that helps determine qualified R&D activity, which is as follows:

  1. Elimination of Uncertainty- Called the Section 174 test, this test involves creating a fully functional representation of the product or improved component of an existing product, to eliminate any uncertainty concerning the success of the development. For example, a product that has been changed solely for aesthetic purposes would not qualify for the R&D tax credit.
  2. Process of Experimentation- Through modeling, simulation and trial and error, you must demonstrate that you’ve evaluated alternatives for achieving the desired result of your research.
  3. Technological in Nature (The Discovering Technological Information Test) - You must rely on the hard sciences (includes physics, biology, computer science, engineering, chemistry) to make sure the research activity is technological in nature.
  4. Qualified purpose (The Business Component Test) - The research must be wholly devoted to creating a new or improved product that will increase functionality and overall quality.

Change in #1 of the Four-Part Test

Noted by some as the most significant change from the proposed regulations (set forth January 2015) is that the IRS restored something called “appropriateness of design” as an uncertainty for IUS. This means that IUS research activities that involve uncertainty related to appropriate design of the new or improved product (and not capability or methodology) would rarely qualify as having significant uncertainty.

Final regulations: Highlights

Here’s a summary of the final IRS regulations:

  • General and administrative (G&A) functions are limited to financial management functions, human resource management functions and support services.
  • To determine whether the software is IUS or non-IUS, you have to analyze the taxpayer’s intent and the facts and circumstances at the beginning of the development of the new software.
    • Non-IUS software includes software that is developed to be commercially sold, leased, licensed or otherwise marketed to third parties.
    • Software developed to allow taxpayers to interact with third parties or that allow third parties to initiate parties to initiate functions or review data on a taxpayer’s systems is also not considered ‘developed for internal use’.
  • Something called connectivity software allows multiple processes to run on one or more machines to interact across a network. Determining whether this software is IUS depends on the function of the software (not the type).
  • Dual function software was designed for G&A functions only, but allows the taxpayer to identify a subset of the software development that allows interaction with a 3rd party.
  • Companies who develop software for other companies to use can still qualify for the research credit under the final regs.
  • IUS still qualifies for the credit if, in addition to the 4 part test described above, it meets the following “High Threshold of Innovation Test”:
    • Software is innovative- If the development is or would’ve been successful, and will/would’ve resulted in a substantial drop in cost or improvement in other performance metrics, it is considered innovative, and therefore the credit still applies.
    • Involved major economic risk- If the taxpayer uses substantial resources for the development and there’s doubt whether resources used will be regained within a reasonable period (because of the technical risk involved in the development), the credit still applies.
    • The software is not commercially available- If the taxpayer is not able to buy, lease, or license purchased software without considerable modification and expense, the credit would still apply.

Wondering if your activities qualify for the R&D tax credit? Contact us.