How to Capture Research Tax Credit for Internal-Use Software

Late last year, the IRS issued final regulations providing rules for taxpayers who develop their own internal-use software and want to claim a research tax credit (research credit). These changes, initially proposed in 2015, were highly anticipated. But little is known about how to take full advantage of the credit since the new rules were released.

The final regulations define internal-use software as software developed by or on behalf of the taxpayer for use in general and administrative functions that facilitate or support the taxpayer’s trade or business. This is intended to target the back-office functions including:

1. Financial management – record keeping such as accounting, inventory management, budgeting and forecasting, financial reporting, and tax;
2. Human resource management – hiring and training employees, payroll, and benefits;
3. Support services – data processing, facility management, marketing, and security services.

The Innovation Test

The general rule states that software developed primarily for the taxpayer’s general and administrative functions (internal-use software) does not qualify for the research credit. However, the finalized regulations create an exception for certain software projects that meet a “high threshold of innovation test.” This test is met only if the taxpayer can establish that the software:

1. Is innovative: Software is innovative if it would help the taxpayer achieve a reduction in cost, an improvement in speed, or some other measurable improvement. This improvement needs to be both substantial and economically significant.

2. Involves significant economic risk: Software development involves significant economic risk if the taxpayer commits substantial resources to the development and there is substantial uncertainty that those resources will be recovered within a reasonable timeframe.

3. Is not commercially available.

This “innovation test” applies only to internal-use software. The determination of whether these standards are met will vary for each taxpayer.

Dual-Function Subset

Taxpayers must prove that software serving both general and administrative functions and other functions (dual-function software) was developed for internal use. Taxpayers must also identify elements of the software that enable the taxpayer to interact with third parties, or allow third parties to initiate functions or review data (referred to as a “dual-function subset”). If the software serves both internal and external sources, it must be reviewed as having separate uses. The costs of the external/third-party elements would not be included in the costs of the “internally developed software” piece. These costs, however, may be eligible for the research credit under separate standards.

If a taxpayer is unable to specifically identify this dual-function subset, the regulations offer a safe harbor alternative. Under the safe harbor, if a taxpayer reasonably anticipated at the onset of the software’s development that at least 10 percent of the use would be by third parties or by the taxpayer on behalf of third parties, 25 percent of the research and development costs related to the software are eligible for the credit.

If your company is involved in the research and development of software, you may be able to benefit from the research credit. For more information, please contact your KSM advisor.