The final regulations define internal-use software as software developed for general and administrative functions that facilitate the taxpayer’s business, such as financial management, human resource management, and support services. However, the IRS acknowledged the dual functionality of certain software that not only supports the taxpayer’s internal business operations but also facilitates third-party interactions. For example, a pizza parlor that develops software to manage its order and fulfillment process clearly uses the software for internal purposes; however, if the consumer can access that same software to place or modify the order or track the delivery of the pizza, the software can also be considered external-use because it enables third-party interaction. The IRS’s response was to include a dual-function rule that allows a portion of the qualifying costs (those related to third-party interaction) to be allocable towards the research credit.
If the taxpayer cannot specifically identify which elements of the software are for internal or external use, the regulations also offer a safe harbor alternative. Under the safe harbor, the taxpayer can capture 25% of the qualifying costs towards the research credit as long as at least 10% of the software’s use will be for third-party functions.
Finally, software that falls under the standard definition of internal use and does not qualify as dual-function may still be eligible for the research credit if it meets a “high threshold of innovation test.” To meet this test, the software must:
- Be innovative: there should be a “reduction in cost or improvement in speed or other measurable improvement, that is substantial and economically significant, if the development is or would have been successful”
- Involve significant economic risk: the taxpayer must commit “substantial resources to the development and there is a substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period”
- Not 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”
The final regulations significantly increase the reach and impact of the R&D Tax Credit. With the growing reliance on software in most industries, this regulation could not only make the research credit accessible to businesses that have historically been excluded, but also increase the size of the credit for all businesses.
If you are involved in software development, the R&D Tax Credit is an opportunity that must be considered. With the recent changes to the tax code, including the repeal of the corporate AMT and a lower tax rate, as well as the two significant amendments made to the R&D Tax Credit in 2015 to support small businesses, the R&D Tax Credit is more accessible and stronger than ever and could generate significant savings for your business. For further information or a complimentary assessment of your eligibility and potential credit size, contact us today.