R&D tax credits clarified for internal use software

  • September 24, 2015
  • Mark Hughes CPA CFE

Most-common-tax-deductionsThis article appeared in Accounting Today.

Proposed regulations released by the Treasury Department in January provide guidance on the definition of internal use software for the R&D tax credit.

The IRS regulations help clear up the confusion that has long reigned over what is truly considered internal use software development, as opposed to software developed with the intent to sell, lease or license it.

It is important to note that this proposed Treasury regulation is for prospective purposes only, meaning only tax years ending after the Treasury decision will be eligible for this new treatment. Open tax years of Dec. 31, 2014, and prior tax years, fall under the previous guidance.

Prior to the passage of these regulations, if a taxpayer was not selling software in the commercial market, their development efforts were required to pass the four standard qualifying criteria, in addition to a three-part test. Internal use software had to: 1) pass an innovation test; 2) be commercially unavailable; and 3) involve significant economic risk. Navigating these requirements resulted in conflicting interpretations among taxpayers and the IRS.

The proposed Treasury regulations clarify that taxpayers who develop software for a third-party commercial focus should no longer face uncertainty as to whether or not their software development will be classified as internal use software. Software development that allows third parties (customers and vendors) to interact and conduct transactions with the taxpayer will be considered external use software and not subject to the additional qualifying criteria that internal use software is held to.

Software development activities that are designed for the purposes of financial management, human resources and other back office support will now be the activities that are considered internal use software.

Many taxpayers develop software projects with the purpose of improving internal efficiencies and effectiveness. If development efforts are successful, companies then decide to release it to the commercial market.

The proposed Treasury regulations detail these circumstances as well. Every situation needs to be qualified on a case by case basis, but there are clear guidelines now on how to handle each one under the R&D tax credit. This dual function software will continue to be considered internal use software, but if a taxpayer can demonstrate how the software development has transitioned to a third-party purpose, then the costs associated with the additional development can potentially be included.

An increasing number of companies with internal software projects should be able to qualify for the R&D tax credit. Many businesses with software development investments may be incurring enough expenses to generate measurable tax savings. An investment can generate meaningful tax savings when you consider that the effective federal tax credit is 5 to 6.5 percent of the investment with applicable state tax credits.

In the months following this regulation, I have had many conversations with companies that invest significantly in software in order to be competitive within their respective industries. Software development isn’t cheap and the typical development cycle isn’t quick. While the expense of outside contractors and employees’ time can be a hit to the income statement, these costs can now generate federal and, where applicable, state tax credits that offset future taxes.