Research and development (R&D). Often this phrase conjures images of mysterious laboratories ‘at the far end of the hall’ bubbling with beakers, test tubes, and crisp lab coats stuffed with pensive scientists hunching over microscopes and test results.
But R&D is so much more. And fortunately for many organizations, the IRS’s interpretation of R&D steps out of the lab and expands into a wide and varying swath of business endeavors that potentially qualify. One of those qualifying areas is software development.
Learn how the Tax Cuts and Jobs Act increases the potential benefit for claiming tax credits for research
Generally, under IRC Section 41, the federal government grants R&D tax credits for software development and other research activities that satisfy the following four-part criteria:
- Business Component
The activities of a company to develop new or improved business component, in this case software, for a permitted purpose of function, performance, reliability or quality to be held for sale, lease, or license, or used by the company in its trade or business. (Secs. 41(d)(1)(B)(ii) and (d)(2)(B))1. - Elimination of Uncertainty
The activities to develop the software must be intended to discover information to eliminate uncertainty regarding the capability or methodology for development or improvement of a product, process, or the appropriate design (Sec. 41(d)(1)(A)). - Process of Experimentation
The development of the software must have been subjected to a process of experimentation consisting of evaluating alternative designs, testing hypothesis, and/or systemic trial and error (Sec. 41(d)(1)(A)). - Technological in Nature
The activities undertaken to develop the software must fundamentally rely on principles of physical, biological, computer, or engineering science (Sec. 41(d)(1)(B)(i)).
If a company’s software passes through the above gauntlet, they can most likely capture the tax credit. However, because of perplexing and sometimes ambiguous language and guidance, many enterprises missed out on R&D claims for their internal-use software (IUS) due to the requirement to meet a higher standard than the four-part test listed above. In 2015, the IRS responded by building more clarity into its R&D regulations, thus opening more IUS credit opportunities for businesses.
Internal-use Software Defined
The IRS interprets IUS as software that the business has developed (or adopted) to manage general and administrative functions, which support or facilitate the company’s trade or business.
The IUS must also survive the three-part High Threshold of Innovation test to qualify:
- Is It Innovative?
The software must prove to be innovative in that it will cut costs, bolster efficiency and speed, or supply other measurable business improvements. - Does It Possess Economic Risk?
The company must endure significant economic risk by committing considerable resources to the software’s development and tolerate substantial uncertainty of recovering those resources within a reasonable period. - Is It Commercially Available?
If the software can be purchased, licensed, or leased for the intended purpose without modification, the software cannot be claimed as internal-use status.
Dual-Function Software
But what about software that was developed for both interaction with third-parties and for internal use? The regulations assume that dual-function software is primarily internal, such as software created for inventory management that also bears functions that may permit a business to interact with third-parties.
However, this assumption may be overridden if the company can identify subsets that would not be considered internal, such as elements which facilitate third-party interaction or enable third-parties to initiate functions or review data on the company’s system (third-party subset).
The U.S. government has provided a safe harbor that allows businesses to snag 25% of research expenses of the dual-function software to calculate the research credit – so far as the third-parties functions are expected to encompass at least 10% of software usage.
Seek Navigation Through the Regulations
Do these internal-use R&D credit requirements feel intimidating? You’re certainly not alone. The R&D tax credit is a highly complex area…but well worth the pursuit. Reaching out to R&D specialists can deliver guidance and knowledge to help you capture your deserved credits and maximize your return.
Partner with CTI’s expert team of attorneys, CPAs, engineers, and scientists to steer you through R&D credit complexities and claim your qualified internal-use software.
1. Sect. 41 Credit for Increasing Research Activities, IRS https://www.irs.gov/pub/irs-regs/research_credit_basic_sec41.pdf
