Jon Seagraves, JD, EA
There are a number of misconceptions out there concerning the eligibility of expenses incurred in the development of internal use software for the R&D tax credit. These include a belief that internal use software development doesn’t qualify for the credit and a belief that only companies in industries typically associated with the term “research and development” (i.e. pharmaceutical companies or manufacturers developing new products) can claim the credit. This could not be further from the truth.
In order to claim the R&D tax credit for internal use software development expenses, the activity giving rise to those expenses must satisfy the general four-part test for credit eligibility. This means that the development activities must:
1) Be undertaken for a permitted purpose, meaning that you are attempting to develop a new or improved function, performance, reliability, or quality for a product, process, formula, invention, software, or technique to be sold, leased, or licensed, or used in your trade or business.
2) Attempt to resolve technical uncertainty, such as capability uncertainty or uncertainty as to the appropriate design or methodology to utilize.
3) Be technological in nature, meaning they rely on principles of the physical or biological sciences, engineering, or computer science.
4) Utilize a process of experimentation, which is a process of evaluating one or more alternatives, and can include things like modeling, simulation, or systematic trial-and-error, to attempt to resolve the technical uncertainty faced.
There are some additional specific exclusions to consider as well, one of which is that in order for internal use software to qualify, it must satisfy what is known as the “high threshold of innovation test,” which is an additional three-pronged test.
High Threshold of Innovation Test
In order for internal use software development to qualify for the R&D tax credit, in addition to satisfying the four-part test above, it must also:
1) Be innovative, meaning that if development is successful it would result in a reduction in cost or improvement in speed or other measurable improvements that is substantial and economically significant.
2) Involve significant economic risk, meaning that substantial resources are committed to development and that due to technical risk there is substantial uncertainty that those resources will be recovered within a reasonable period.
3) Not have a commercially available alternative which could be purchased, leased, or licensed for the intended purpose without requiring modifications that would satisfy the two prongs above.
In order to determine whether or not the high threshold of innovation test applies, it first needs to be determined whether or not the software being developed is actually internal use software.
Definition of Internal Use Software
For purposes of the R&D tax credit, software is considered internal use software if it is developed for use in general and administrative functions that facilitate or support the conduct of the company’s trade or business. This includes financial management functions (such as accounts payable/receivable, inventory management, budgeting, financial reporting, and general ledger bookkeeping), human resources management functions (such as recruiting, training, assigning personnel, and maintaining personnel records), and support service functions (such as data processing, security services, facility services, and government compliance services).
Software developed to be commercially sold, leased, licensed, or otherwise marketed to third parties, or that is developed to enable a company to interact with third parties or to allow third parties to initiate functions or review data on the company’s system, is not considered internal use software. If the software is a mixture of internal use and non-internal use aspects, then the high threshold of innovation test does not apply to the portion which is non-internal use.
Taxpayers in a number of industries may incur expenses developing internal use software (or partially-internal use software) which could potentially qualify for the credit. Examples include a pest control company developing a software system to enable customers to schedule service and for the company to assign service calls to employees and manage their schedules and workload, and a logistics company developing software to enable inventory quantities and inventory locations within facilities to be tracked, as well as for orders to be received and tracking during fulfillment and shipment electronically. As another example, a construction company may wish to develop a custom and comprehensive construction management platform that allows for clients to view project status and perform other functions, for subcontractors to submit RFI’s (and for the company to provide responses) and invoices as well as perform other functions, and for the company to perform a variety of functions including project cost accounting, forecasting, and labor and equipment scheduling.
When evaluating potential internal use software expenses for the R&D tax credit, it’s important to begin by analyzing whether or not the software development satisfies the basic four-part test for the credit, then determine which portions of the software development activities (if any) are considered internal use software, and finally, to ensure that any aspects of the software deemed to be internal use satisfy the high threshold of innovation test. Working with experienced advisors can be extremely beneficial in this analysis.
If your company incurred internal use software development expenses that you feel might qualify for the R&D tax credit, email us at firstname.lastname@example.org or give us a call at (800) 624-1076. We will ensure that your company receives the maximum possible tax saving on your R&D expenditures!