How to Leverage the R&D Tax Credit for Internal-Use Software

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Posted by Randy Eickhoff on Jan 28, 2020 1:26:11 PM

The Research and Development (R&D) tax credit rewards businesses with qualifying R&D operations. Unfortunately, demonstrating R&D tax-credit eligibility has mystified taxpayers since the IRS launched its R&D tax program in 1981. Among the most elusive activities to qualify is internal-use software (IUS) development.

Internal-Use Software Development Qualifies as R&D

Companies investing in software development to improve products or processes often miss out on claiming the federal R&D tax credit. But entities engaging in these activities are perfectly positioned to take advantage of this lucrative incentive due to extensive R&D during software design and development.

What is Internal-Use Software (IUS)?

IUS is company created and used within the confines of internal day-to-day operations. In January 2015, the IRS revised its definitions of IUS to encompass general administrative functions. These changes opened the door for companies to benefit from developing software for “back-office” work or supporting commerce.

The IRS Updated IUS Requirements for R&D in 2015

The updated IRS regulations in Section 41 clarify requirements for qualifying activities associated with internal-use technologies. Similar to all qualified research expenditures (QREs), IUS disbursements must pass the four-part test.

An activity must:

  • Serve a permitted purpose
  • Eliminate technical uncertainty
  • Have a technical nature
  • Demonstrate a process of experimentation

However, beyond meeting these requirements, internal innovations including IUS also must pass the “high threshold of innovation test,” which includes three subtests:

The Innovation Test

IUS must demonstrate innovation: reducing costs, improving speed, or measurably enhancing an economically significant factor.

The Significant Economic Risk Test

IUS development must involve significant economic risk. Businesses must demonstrate not only substantial investment during development, but also measurable uncertainty that these expenses may not be recovered within a reasonable timeframe.

The Commercial Availability Test

IUS cannot be already commercially available. The technology cannot be leased, licensed, purchased, or used without modifications satisfying the Innovation and Significant Economic Risk Tests.

Examples of IUS and Functions

IUS encompasses many programs and technological solutions, ranging from payroll applications to inventory management systems. Common examples of IUS serve the following functions:

General Administrative Functions

  • Accounting, Banking Transactions, and Financial Systems
  • Customer Relationship Management (CRM)
  • Data Analytics and Business Intelligence Solutions
  • Data Privacy and Security 
  • Facilities Services, Manufacturing, Production Process, and Quality Control (QC)
  • Human Resources (HR) Management
  • Inventory Management 
  • Marketing and Sales
  • Payroll Management
  • Support Service 
  • Risk Management (RM)

Connectivity Software

Connectivity software, commonly called "bridging software," is an IUS allowing at least two computer systems to communicate over a network (i.e., share data). Connectivity software supports internal operations by automating business processes and streamlining communication.

Dual-Use Software

Dual-use software is an IUS with features for both internal and external use. Internal-use features may include financial tracking, while external features are used by clients or customers. Examples of dual-use software include online customer-service portals and cloud-based project management (PM) tools.

What Technology Does Not Qualify as IUS

Non-internal-use software falls into two specific categories:

  • Technology designed by a taxpayer to be commercially sold, leased, licensed, or marketed to external business entities 
  • Technology developed either to enable a company to engage with external business entities, or to enable external business entities to launch functions or evaluate taxpayers’ internal information

Does Your IUS Qualify for the R&D Tax Credit?

Many businesses still struggle to identify whether their operations or technologies qualify for the R&D tax credit. Acena Consulting can help. Contact us today to speak with our team of experienced tax consultants. We can help you identify and claim each of your eligible R&D expenses.

Randy Eickhoff

Randy Eickhoff

Acena Consulting President Randy Eickhoff, licensed CPA, has partnered with more than 200 companies during more than 20 years of experience securing tax credits and other government incentives. His corporate partners range from multinational technology firms to smaller, privately held manufacturing, sports, and technology enterprises.