Qualifying Internal Use Software Development & the R&D Tax Credit

When developing software, there are many questions that must be addressed before claiming the U.S. R&D Tax Credit. Since 2016, one vital distinction that must be made is identifying whether the software is being developed for internal use, sales/lease, or dual function. Internal Use Software (IUS) refers to software developed by a taxpayer for general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business. These general and administrative functions have been defined by the IRS and are limited to:

1. Financial Management: Functions that allow a taxpayer to manage financial functions, such as accounting, procurement, tax planning, investments, and/or bookkeeping.
2. Human Resource Management: Functions that allow a taxpayer to manage its workforce resources, such as talent acquisition, performance analysis, continuous development, and/or employee wellness.
3. Support Services: Functions that allow a taxpayer to support the day-to-day operations of the taxpayer, such as data processing, facilities services, incident management, and/or customer service.

Many taxpayers develop software that is not primarily for internal use. These types of software are built to be sold, leased, licensed, or marketed to third parties. Non-internal software can also enable the taxpayer to interact with third parties or allow them to initiate functions or review data. Whether the software is IUS or not, to qualify for the R&D Tax Credit, the software project must pass the four-part test that all types of projects must pass. The software must be developed for a permitted purpose, the development of the software must be technological in nature, there must be technical uncertainty in the development process of the software, and there must be a process of experimentation in the development of the software.

In addition to the four-part test, IUS must also satisfy the high threshold of innovation test to qualify for the R&D Tax Credit. The three additional criteria for the high threshold of innovation test speak to the productivity value, financial interest, and functional need of the IUS being developed. The high threshold of innovation test is defined in Regs. Sec. 1.41-4(c)(6)(vii) and has three parts:

1. The intention of the IUS must be highly innovative as measured by a reduction in cost, improvement in speed, or other measurable improvement that is substantial and economically significant.
2. The development of the IUS must expend a significant economic risk in that the taxpayer commits substantial resources to the development and there is substantial uncertainty because of technical risk as to whether the resources can be recovered within a reasonable time.
3. The new information being discovered during the development of the IUS cannot be commercially available. The software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant economic risk requirements.

When developing IUS, the IRS emphasizes that the taxpayer’s intent at the beginning of the development process is crucial in determining the classification. A unique circumstance that may affect a taxpayer claiming the development of an IUS as a qualified business component but later makes improvements to the software with the intent to offer the software for commercial sale, lease, or license. The guidelines state that software developed with the intent of originally being built as an IUS must still pass the four-part test and the high threshold of innovation test. Similarly, if a taxpayer originally develops software for commercial sale, lease, or license, but later makes improvements to the software with the intent to use the software in general and administrative functions, the improvements will be a separate business component from the existing software and will be considered developed primarily for internal use.

In conclusion, navigating the complexities of the U.S. R&D Tax Credit, particularly in relation to software development, requires a clear understanding of the distinction between IUS and non-internal software.  For IUS, the taxpayer must demonstrate that the software is being developed for internal general and administrative functions and must prove that it provides substantial technical improvements, undertakes significant economic risk, and cannot be commercially obtained. Taxpayers developing software should discuss with an R&D Tax Credit consultant who can carefully assess their intent and the functionality of their projects from the outset to determine whether they meet the requirements for the R&D Tax Credit.