Congressional intent has always been the cornerstone for how laws enacted by Congress are administered by Treasury (aka The Internal Revenue Service). Within the depths and detail of the Research and Development Tax Credit, following congressional intent has always been a challenge for the IRS (and for taxpayers, for that matter). But in order to properly execute the wishes of Congress, regulations, forms and other guidance need to be written and followed.

Bifurcating Software Development

In the case of R&D tax credits and software development, Congress made a distinction between software developed for customers and software developed to be used inside a business. The IRS, attempting to administer congressional intent, developed stringent regulations around software developed for internal use. These regulations are broken into a three-prong test known as the Higher Threshold of Innovation Test. This test and its application to analyzing software developed by taxpayers for internal use has been a topic the IRS and taxpayers have fought over for many years..3-Prong

Test Known as the Higher Threshold of Innovation

The three prongs of the Higher Threshold of Innovation Test are (1) the software is innovative; (2) the software development involves significant economic risk; and (3) the software is not commercially available.

While having specific definable and detailed regulations and black and while legislative history is always preferred, each prong in the test carries a degree of subjectivity. With no bright line test, battle lines are drawn during an audit and additional efforts to properly document (or audit) each development effort the taxpayer wishes to qualify cost hours. The courts have helped better define congressional intent, but the Higher Threshold of Innovation test continues to be a difficult road to follow.

Over the next month, we will expand and discuss the details around the Higher Threshold of Innovation Test and its application in the real world. While final regulations have not been forthcoming as yet, temporary regulations, court cases, and other guidance have helped the taxpayer to understand the types of development activities will qualify for R&D tax credits.

Randy Eickhoff, CPA is President of Acena Consulting. With more than 20 years of tax and consulting experience, Randy focused on helping companies successfully document and secure tax incentives throughout the US. He has been a long-time speaker nationally as well as conducted numerous training sessions on R&D tax credits and other US tax incentives.