The qualifications for inclusion within the Research and Development Tax Credit (R&D) has been a source of arguments for taxpayers and the IRS since the enactment within the Economic Recovery Tax Act back in 1981. Particularly contentious have been the costs for the internal-use software. In January of 2015, the IRS released new proposed regulations to help provide clear rules regarding R&D with regard to internal use software.
The federal R&D tax credit is governed by Sec. 41 and its regulations. To begin the defining process of what qualifies as internal use software, all qualified expenditures must begin by passing a four-stage test to be deemed as qualified QREs and remain eligible to receive the credit. These four steps include determining:
- Permitted Purpose
- Elimination of Uncertainty
- Technical Nature
- Process of Experimentation
While external-use software meets only this four-part test, any internal-use software must also pass a three step “high threshold of innovation” test:
- The Software is innovative, resulting in cost reduction or improvement of speed or another measurable improvement that is economically significant.
- The development of the software involves significant risks. The taxpayer has invested resources to create the software, and because of the risks involved there is uncertainty that the costs for the development will not be recovered within a reasonable amount of time.
- The software being developed cannot be commercially available for taxpayers use. Meaning it isn’t available without significant modifications. Meaning it can’t be bought, leased, licensed or used for an intended purpose without changes that would satisfy the other two requirements above.
2015 proposed regulations also limit the definition of internal-use software by more clearly stating what is not internal use software. These proposed regulations define the following as non-internal use software:
- Software created by a taxpayer that is intended to be commercially sold, licensed, leased or otherwise being marketed to third parties;
- Software created to allow a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system.
Since the R&D tax credit began, it has provided a tremendous amount of benefit to taxpayers who incur and invest in domestic research expenses. While this tax is not currently a part of the permanent tax laws, it has been continuously extended as a part of the Tax Increase Prevention Act. Many taxpayers taking advantage of the benefit year after year are hopeful to see it become part of the permanent tax code at some point in the future.
If you are uncertain about how to navigate the evolving world of R&D tax credits and internal use software requirements, please contact us today to see how we can use our experienced team of tax consultants to help ensure you receive your credit.