New rules make it easier to claim the R&D tax credit
Think only IT firms undertake software development activities that qualify for the Research and Development (R&D) tax credit? Think again. If your company develops software for use in your business, you should be aware of recent regulations issued by the Treasury Department. The new rules broaden the understanding of the types of software that qualify for the R&D tax credit. While the service industry is expected to gain the most from this change, it applies to businesses in all sectors.
The regulation revision narrowed the IRS’s definition of “Internal Use Software” (IUS), which has to meet a higher bar to qualify for the R&D tax credit. The result is that more software will now be considered outside the definition of IUS, and its development will therefore enjoy a less stringent qualification for the credit.
Understanding the distinction
When applying for the R&D credit, there are more hoops to jump through when claiming the development of software the IRS considers IUS. The activity has to meet the traditional four-part test – the same as the activity related to the development of any other product – but it also faces an additional layer to the application process that is more complex and stringent. In the past, the complexity of the process has led many taxpayers to run away from even attempting to claim the R&D tax credit for their work to develop any software used in their business.
Historically, the distinction between the two categories hinged on whether the software was “sold, leased or licensed to a third party.” If it was not, then the IRS considered it to be IUS, and its development was subject to the more stringent rules.
However, under the new regulations, the distinction has been redefined. And the revised regulations seem to indicate that the Treasury Department recognizes that many businesses are developing software to help run their business and at the same time facilitate sales or otherwise interact with customers externally via their website.
Under the regulations most recently issued, software is not considered IUS if it is “sold, leased, licensed or otherwise marketed to third parties.” Additionally, the Treasury Department added language that clarifies that the definition of IUS only refers to software that is developed for general and administrative functions that facilitate or support a taxpayer’s trade or business. The IRS has defined “general” and “administrative” in the regulations, and they are limited to any system used to run the business such as financial management, human resources or support services. Most exciting in the new rules is language stating that software enabling a business to interact with a third party (customers) is excluded from the definition of IUS.
Of course, the development of software that falls outside of this newer description of IUS will still have to meet the R&D tax credit’s traditional four-part test; but it will not be subject to the more stringent IUS rules for claiming the R&D credit, and that presents many taxpayers an opportunity.
Adopting the rules as final regulations
These new regulations are applicable for tax years ending on or after the publication date of the Treasury decision adopting these rules as final regulations in the Federal register. However, the IRS will not challenge positions consistent with these proposed regulations for taxable years ending on or after January 20, 2015.
Further resources for understanding the R&D tax Credit:
- Understanding the R&D Tax Credit: a recorded webinar
- How available is the R&D tax credit? More than you might realize
- What qualifies as research, and how do I document it?
- How the credit adds value to your business
- Know the process: an R&D study has three stages
- How all 10 profit boosting ideas can work at your company
- Back to the 10 profit boosting ideas homepage