Final regulations for the R&D tax credit expand and clarify the definition of internal use software (IUS).
Published October 4, 2016, the regulations lift some eligibility requirements for certain software development activities. The changes aim to make the tax credit more readily available to small businesses and others whose software development activities may not previously have been eligible for the credit.
The final regulations are generally consistent with the temporary regulations released January 16, 2015. IUS development is still subject to additional eligibility rules, referred to as the “higher threshold of innovation” tests, beyond the rules for non-IUS R&D activities.
However, the new rules provide clarification on how IUS is defined. As a result, software intended to benefit an unrelated third party—for example, a customer or business partner—may not be considered IUS and therefore isn’t subject to the more rigid eligibility requirements. In contrast, back-office software development, such as functions related to HR, payroll, and finance, is considered IUS and subject to the higher threshold of innovation requirements.
By clarifying what is and isn’t IUS, the final regulations open the door for more software development activities to potentially qualify for the credit.
What Software Is Eligible?
To illustrate what types of software are now eligible to claim the credit without meeting the higher threshold of innovation IUS requirements, the final regulations use the example of an e-commerce Web site. In the past, the software developed to allow a site to manage orders and process transactions may have been subject to IUS requirements, since it isn’t licensed or sold to its users. Now, because software users receive the benefit of that technology, the activities involved to create this software may not be considered IUS and therefore wouldn’t be subject to the higher threshold of innovation requirements.
Though many forms of software development were always intended to be eligible for the R&D tax credit, it’s an area that’s traditionally been subject to more controversy than many other types of R&D activities. This is evident in the number of court cases over the past 10 years and the complexity of the IUS rules—which have been included in the IRS’s priority guidance plan for the past few years.
Since the eligibility rules were first defined in the 1980s, software development has advanced in new directions that the regulations have been slow to adapt to. As a result, these changes should come as a welcome change for many developers and others who perform software development in support of their other operations.
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Although software developers are the most obvious taxpayers likely to benefit from the changes, businesses that develop software for third-party use in any industry may also qualify—including retailers, airlines, banks, and many others. If you develop software for either internal or third-party use, this is an opportunity to take a closer look at whether your activities may qualify for the R&D tax credit. For questions or to discuss any development activities that may be eligible for the credit, contact a Moss Adams tax professional or e-mail firstname.lastname@example.org. Or become a part of the conversation and stay up to date on R&D-related news by joining the Moss Adams R&D Tax Credits Forum on LinkedIn.