IRS rulings affecting R&D tax credit

IRS Rulings Affecting the R&D Tax Credit

Bruce Stubbs, JD, LLM

Bruce Stubbs, JD, LLM

Restrictions on “internal-use software” expenses qualifying for R&D tax credits eased

By Bruce Stubbs
AGH Specialized Tax Solutions
May 29, 2015

A new and narrower IRS definition of what constitutes “internal-use software” opens the door for claiming research and development tax credits for more companies.

The R&D tax credit allows taxpayers to claim tax credits, in addition to their deductions, for qualified expenses related to software development – unless that software was created for internal use only. Historically, unless the software was developed specifically to be sold, leased, licensed or otherwise marketed outside the company, it was considered to be for “internal use.”

In January 2015, the IRS proposed regulations would limit the definition of internal-use software to software developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business, basically software to support “back-office” type functions, such as financial management, human resources, and support services (i.e., day-to-day type activities). By contrast, expenses related to software developed for interactions or transactions with third parties or for both internal and external use could potentially qualify for R&D tax credits.

Examples of this kind of third-party software might be a program written to allow a taxpayer to interact with a bank, track inventory or deliveries, or allow a customer to view information on the taxpayer’s systems. In addition to this potential eligibility, software which is developed with a “high threshold of innovation” may also be eligible for R&D tax credits, even if it is primarily for internal use. This is the same high threshold of innovation test as in prior guidance.

The proposed regulations, once finalized, would become effective on a prospective basis only. However, the IRS has indicated they do not plan to challenge taxpayer returns which follow the proposed regulations for tax years ending on or after Jan. 20, 2015. For more information on the internal use software regs, visit this page.

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