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

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Posted by Brad Mols on Jan 28, 2020 1:26:11 PM

Since 1981, the research and development tax credit has rewarded organizations that demonstrate qualifying R&D operations. While the program was developed to benefit businesses that prioritize innovation, like many tax initiatives, eligibility for the credit has confused taxpayers since its launch. One especially unclear component of qualification for the benefit? The costs associated with internal-use software.

Internal-Use Software R&D Requirements Updated in 2015

Fortunately, recent changes to the innovation tax credit have made it easier for companies to navigate through benefits offered on internal-use software. In January 2015, the IRS updated regulations found in Section 41 to provide taxpayers with clearly defined requirements on the eligible, internally used technology. Like other relevant expenditures, internal-use software disbursements must pass the mandatory four-part test for qualified research expenses (QREs). An activity must:

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

However, beyond the standard four-part test that typical software development must pass, internal innovation must also meet the requirements outlined in the three-step test known as the "high threshold of innovation," which includes:

The software must show that it's innovative, allowing the business entity to reduce costs, improve speed, or demonstrate measurable enhancement of an economically significant factor. 

Significant Economic Risk
The taxpayer must show that developing the internal-use software in question involves significant economic risk. Business owners must prove they've invested substantial resources to further the development process. Additionally, corporate entities must demonstrate measurable uncertainty that the development expenses may not be recovered within a reasonable timeframe. 

Not Commercially Available
Finally, taxpayers must prove their internal-use software is not already commercially available. Specifically, the technology cannot be purchased, leased, or licensed, or used without making modifications that satisfy the innovation and economic risk requirements. 

What Is Not Internal-Use Software
The 2015 final regulations for defining internal-use software more clearly define when software development must be classified as internal-use software development, and when it is not. According to the recent legislation, non-internal-use software falls into two specific categories:

  • Technology designed by a taxpayer to be commercially sold, licensed, leased, or marketing to external business entities 
  • Technology developed to enable a company to engage with external business entities or to enable external business entities to launch functions or evaluate the taxpayer's internal information

Does Your Internal-Use Software Qualify for the Research and Development Tax Credit?
Despite the recent changes to the R&D tax credit, many business owners still struggle to identify if their operations or technologies qualify for the benefit. If you're struggling to optimize the research and development 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 all of your eligible R&D expenses. 

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