Internally Developed Software Tax Treatment: Claiming the R&D Tax Credit for Internal Use Software

The Research and Development (R&D) Tax Credit is a permanent federal tax incentive intended to stimulate innovation, technical design and manufacturing within the U.S. Many taxpayers associate these valuable tax credits with work conducted by a scientist or engineer. However, over the years, the IRS has expanded the incentive to include other industries and services, such as internal use software.

The IRS regulations, finalized in 2016, define internal use software as software developed for use in the taxpayer's general and administrative functions, such as financial management, human resource management and support services functions.

Which Internal Use Software Qualifies for the R&D Tax Credit?

To qualify for the R&D tax credit, the internal use software needs to meet a high-threshold-of-innovation test. For example, the software cannot be commercially available. The regulations also clarify that software marketed to unrelated third parties to initiate function or review data using the taxpayer’s systems is not internal use software.

With that said, there are two situations when software developed for a company's operations does not need to be considered innovative to qualify for the R&D tax credit. These include:

  1. If the software is developed to facilitate the viability of business interactions with third parties, such as executing banking transactions or tracking deliveries.
  2. When the software is developed to function as a software portal that enables third parties to execute actions on the taxpayer’s software system. In addition to banks and brokerage firms, this includes retailers that have functional websites and phone apps that interface with their clients and customers. In fact, the development of the underlying software for these websites and apps will very likely qualify for the R&D Tax Credit.

High-Threshold-of-Innovation Test

To meet the eligibility criteria for the R&D Tax Credit, the internal use software must meet the following three-part test:

  1. Innovative: The software is intended to be innovative as measured by a reduction in cost, improvement in speed or other measurable improvement that is substantial and economically significant if the development is or would have been successful;
  2. Economic Risk: The software development has significant economic riskin that the taxpayer commits substantial resources to the development and there is substantial uncertainty because of technical risk as to whether the resources can be recovered within a reasonable time; and
  3. Not Commercially Available: Cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant economic risk requirements.

By making certain internal use software eligible for R&D tax credits, the federal government has increased the opportunity for companies and industries that could not previously include expenditures for software developed primarily for their own use.

There are a number of taxpayers whose research tax credits were limited by the higher threshold of innovation test or who did not even claim credits due to this test. These taxpayers should consult with their tax advisers to determine whether their software is now credit-eligible.

R&D Tax Credit Study

Claiming R&D tax credits requires a fair amount of documentation required by the IRS. That’s why it’s important to seek professional help from a consultant with a strong expertise in helping companies successfully claim these valuable tax credits. Our R&D experts dig much deeper into the fundamentals of your business activities—incorporating operations, engineering, financial, and tax expertise that results in more credits and meticulous documentation that is necessary to support your activities, costs, and credit. There is a direct correlation between the amount of your defensible credit and the expertise of the advisor performing the tax credit study.

Learn More R&D Tax Credits for Internal Use Software

The R&D tax experts at Engineered Tax Services have helped companies of all sizes across the U.S. identify and qualify these expenditures and receive the tax benefits they have been missing. Our process begins with an R&D Tax Credit Qualification Analysis to make sure your company qualifies for the R&D tax credit.

To learn more about internally developed software tax treatment and R&D tax credits, please complete the form on this page. For immediate questions about tax deduction for architects, call Engineered Tax Services at (800) 236-6519 or check out our R&D tax credit page for more information.

Author

Heidi Henderson

Heidi Henderson

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