Final Internal Use Software Regulations Create Opportunities for Taxpayers

Final Treasury Regulations were published on October 4, 2016 that make it easier for taxpayers to claim the federal research credit for software development. 

These regulations reverse IRS’ long-standing objections to the eligibility of certain software development activities for the research credit. The final regulations closely follow the proposed internal use software regulations that were published on January 20, 2015, which remains the effective date for the new rules. 

Software developed for third parties must generally satisfy the same requirements as other research and development activities that qualify for the research credit. However, software developed for internal use is subject to an additional high threshold of innovation test. Prior to the new regulations this test required internal use software to be unique and novel from other types of software in order to qualify for the research credit. IRS has long argued that all software is developed for internal use, except software that is developed exclusively for sale, lease or license to third parties. The new regulations provide a narrow definition of internal use software, as well as create a new category of dual function computer software that will allow more software development activities to qualify for the research credit without applying the high threshold of innovation test. When the test does apply, the new regulations significantly lower the level of innovation required to qualify for the research credit. The regulations also create a new safe harbor for software developed for both internal and external use, and provide guidance on when software implementation activities can qualify for the research credit. 

Revised Definitions

The new regulations define internal use software as software developed by the taxpayer (or a related party) for use in general administrative functions that facilitate or support the conduct of the taxpayer’s trade or business. Only three categories of general administrative functions are identified as per se internal use. They are software developed for the taxpayer’s own: 

  1. Financial management functions
  2. Human resource management functions; and
  3. Support services functions.

By narrowing the definition of internal use software, the new regulations eliminate controversy with taxpayers over the need to qualify certain software development activities through application of the high threshold of innovation test. This change opens the door for taxpayers to claim a broader range of development activities. When the high threshold of innovation test does apply, the new regulations eliminate the language in the prior obsolete regulations that required unique or novel features or functionality for the software in order to qualify for the credit. The final regulations dramatically lower the level of software innovation required to qualify for the credit. The new high threshold of innovation test has three parts: 

  1. The software must be intended to reduce cost, improve speed, or make some other measurable improvement in the taxpayer’s business; 
  2. Development must involve significant economic risk, which only exists if there is technical uncertainty at the outset of the software development effort; and
  3. There can be no commercially available alternatives to self-development.

Dual Function Computer Software and a New Safe Harbor

Under the new regulations, most software is dual function computer software that may include some functionality developed for the taxpayer’s internal use, but also allows third parties to access the taxpayer’s systems to review data or initiate functions. Mobile apps, cloud- or web-based software and software-as-a-service platforms fall into this category. For these development efforts, taxpayers are allowed to carve out the development expense for the third-party subset and qualify that portion of the research activity without applying the high threshold of innovation test. If the taxpayer cannot segregate the expense related to the third-party subset, the regulations create a new dual function computer software safe harbor, in which 25% of the cost associated with development of the software will be allowed as qualified research expense. To qualify for the safe harbor, the taxpayer must reasonably anticipate that at least 10% of the software’s use will come from third parties if successfully developed.

Enterprise Resource Planning Software

IRS has long held that enterprise resource planning (ERP) systems implementation is not a qualified research activity because it is the configuration of canned software. The new regulations provide two examples illustrating when software implementation expenses do not qualify for the credit and when they do. In the first example, the cost of an ERP implementation is not a qualified research expense because the taxpayer is configuring the software by selecting options from a variety of menu driven reporting capabilities that are pre-programmed in the software. In the second example, the taxpayer has qualified research expense related to its ERP implementation because the software lacks certain reporting capabilities and the taxpayer must engage in new and original coding to develop the desired functionality. The so called shrinking back rule is applied to isolate the qualified portion of the implementation expense.

Enhanced Opportunities for Software Start-Ups

The Protecting Americans from Tax Hikes Act (the PATH Act) that was signed into law on December 18, 2015, expanded research credit benefits to qualified small businesses that receive less than $5 million in gross receipts in 2016 and have no greater than a five-year history of gross receipts ending with 2016 (meaning they did not receive gross receipts prior to 2012). These benefits include allowing taxpayers to designate up to $250,000 of their research credit to offset a portion of the taxpayer’s FICA payroll tax liability in the subsequent tax year (the payroll tax credit). This election can be made each year for up to five years if the taxpayer remains qualified, which could result in a same-as-cash benefit of up to $1.25 million. When combined with the new favorable regulations governing qualified software development, many small software and technology start-ups are now empowered to reap significant cash benefits from the research credit, even if they are in an overall loss position.

The New Software Regulations and 2016 Year-End Tax Planning

The new regulations are a welcomed improvement over prior regulations governing the eligibility of software development activities for the federal research credit. However, the full benefits of the regulations can only be realized with proper analysis of prior-year activities and some current-year planning for research credits that will be claimed on future tax returns. This is especially true for qualified small businesses that may be eligible to receive the same-as-cash payroll tax credit as soon 2017.