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Internal Use Software and the R&D Tax Credit

June 7, 2022

The banking industry, healthcare, and state and local governments are known for spending a large portion of their IT budget to preserve their aging infrastructure. The U.S. Government Accountability Office (GAO) says that 80% of the government’s $100 billion-dollar IT and cyber budget is spent on maintaining its existing IT infrastructure. 

Rather than streamlining their processes and upgrading their software, medium and large institutions frequently delay a digital transformation as they weigh the costs and benefits of old tech debt against new tech investment. Every delay gives their competitors a chance to innovate before they do.

Legacy software is considered an essential part of day-to-day operations, but it may hold back a company’s progress or scalability. It’s often difficult to upgrade or replace legacy software because companies have grown beyond the tech platform they were founded on. And often, companies may decide to throw money at their technical debt rather than investing in a new solution.

Medium and large companies that are ready to leave behind legacy systems have a tax advantage intended to help them stay relevant and competitive in their industry. If they have departments involved in the development of internal use software, they could benefit from the R&D tax credit for internal use software. 

What Is Internal Use Software?

Internal use software (IUS) is software that is developed or adapted to meet a company’s specific needs. It could serve various purposes such as financial management, internal data management, supporting an external service, increasing connectivity/communication, or improving the human resources department. This translates into software that manages a taxpayer’s workforce, recordkeeping, or data processing.

Before 2016, the definition of internal use software wasn’t broad enough to encompass the different IUS software that a company developed. Vague language and a high threshold-of-innovation test kept most IUS software out of the scope of Qualified Research Expenses (QREs). The earlier definition for QREs focused on software that was commercially licensed or leased, and software sold to third parties. This bypassed the majority of software used internally. 

The Treasury Decision (TD) 9786 by the U.S. Department of the Treasury and the IRS in April 2015 expanded its definition to include IUS. The revised definitions opened the door to companies developing software for “back-office” work or any software that supports the trading abilities of businesses, while refining the definition of IUS to general administrative functions. 

General Administrative Functions 

General administrative functions include human resources, finance management functions and other support service functions. Software for human resources are focused on workforce hiring, payroll and reimbursement management. Company support service functions could include a business’s day-to-day operations for purchase tracking, facilities management, data processing, or content management. 

Connectivity Software

According to TD 9786, connectivity software is defined as a software that allows multiple processes to run on one or more machines that interact across a network, alternatively called bridging software, integration software, or middleware. This software can include customized enterprise resource planning (ERP) software and software with “third-party interactions”, and their requirements differ from company to company.

The functionalities and capabilities the software provides will determine whether it qualifies, and its purpose should be carefully documented for the R&D study.

Dual-Use Software

Dual-use software is defined as software that is not intended to be sold to third parties. If IUS is developed and third parties interact regularly with the company’s software, the software is not considered dual-use. Some examples of this would be banking or ecommerce software. 

Software specifically developed to deliver better service to a customer, like checking the status of an order or accepting customer payments, could be classified as research and development. Carefully documenting the software’s purpose both before and during the development process will build the foundation for an airtight software R&D claim with the IRS. 

The Three-part Test for Internal Use Software

Most software development for sale, lease, or license typically qualifies for R&D tax credits, as long as the software meets the four-part test. Internal use software must pass an additional three-part heightened threshold of innovation test (HTIT) to qualify for the R&D tax credit.

  1. The Innovation Test. The software needs to be significantly different from other implementation methods and provide measurable cost or time benefits to the company.
  2. The Economic Risk Test. The company must expend considerable resources to develop the software without the certainty that the project will succeed. 
  3. The Commercial Availability Test. A comparable third-party software is not available to be purchased, leased, or licensed in the commercial space.

Companies that invest in internal software to solve problems or improve processes could be eligible for tax credits. Certain kinds of IUS may not qualify for tax credits. For example, software applications may not meet the threshold requirements and neither may internal software for ordering online products. Consult with an R&D tax specialist for help navigating this complicated tax claim process.

IUS Rules Do Not Apply Retroactively

Instead of applying the rules retroactively, the IRS has decided that they will apply the rules prospectively. There will be no lookback period for this rule; companies who claim it can only do so from October 4, 2016, the date the new rule was passed. If the company’s IUS was developed between January 20, 2015 and October 4, 2016, the IRS will not challenge returns that were created with the proposed regulations in mind.

For tax years prior to January 20, 2015, taxpayers are allowed to choose to follow the regulations published on January 3, 2001 or the proposed regulations published on December 26, 2001.

Claim R&D Credits for Internal Use Software

If you’ve invested in an internal software system, get cashback from the government for your innovations and reinvest every penny. Navigating the newer parts of the R&D tax code can be confusing—that’s why using a tax specialist is worth it. Contact the Strike Tax Advisory team to claim your R&D funds today.

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