Academic journal article Journal of Accountancy

Internal-Use Software and the Research Credit

Academic journal article Journal of Accountancy

Internal-Use Software and the Research Credit

Article excerpt

EXECUTIVE SUMMARY

* FOR YEARS THERE HAS BEEN LITTLE TAX GUIDANCE for corporations to follow in determining whether internal-use software is eligible for the IRC section 41 research tax credit. In 1997 the Treasury Department released proposed regulations. In the past few years, two court cases, Norwest v. Commissioner and United Stationers, Inc. v. U.S. have shed some additional light on the subject.

* TO QUALIFY INTERNAL-USE SOFTWARE FOR THE CREDIT, companies must essentially meet seven requirements; four come from section 41 itself and three can be found in the proposed regulations. Based on the two court cases, it appears the biggest hurdles are the statutory requirements of discovery and process of experimentation, and the significant economic risk requirement found in the proposed regulations.

* IN UNITED STATIONERS, THE DISTRICT COURT SAID the taxpayer did not qualify for the research credit because its software development activities did not satisfy the discovery and process of experimentation requirements. The court also found the projects did not involve a significant amount of economic risk.

* THE TAX COURT'S NORWEST DECISION REACHED essentially the same conclusion. The court said only one of Norwest's software projects satisfied the requirements for the section 41 research credit. The other projects did not involve significant technical risk, the court said.

* NOT ALL COMPANIES WILL BE HAPPY WITH THE guidance now available on qualifying internal-use software for the research tax credit. The proposed regulations essentially repeat previous guidance, and the court cases do not provide any bright-line tests for taxpayers to follow.

A gray area becomes a little less so.

Computers often need software tailored to a company's needs, but businesses that develop internal-use programs have struggled for years with scant corporate-tax guidance on how to qualify such software for the IRC section 41 research tax credit. A financial manager whose employer plans to develop software in-house may be able to structure such a project more advantageously after looking at the rules and how the courts interpret them.

Although the code does not define internal-use software, the legislative history describes it as software that "supports general and administrative functions (such as payroll, bookkeeping or personnel management) or provides noncomputer services (such as accounting, consulting or banking services)." Enacted as part of the Economic Recovery Tax Act of 1981, the original credit made no direct provision for internal-use software. The accompanying House of Representatives report, however, indicated the credit applied to only new or significantly improved software.

Congress created an opportunity for internal-use software in the Tax Reform Act of 1986 (TRA `86), but ended up leaving it a gray area. The amended credit expressly excluded internal-use software from the definition of qualified research, but included it in two statutory exceptions and in exceptions the regulations would provide. In 1997--more than 1(10 years later--the Treasury Department finally released proposed regulations. Treasury didn't go out on a limb, and the proposals do little more than echo the TRA `86 conference report. Most companies already apply these requirements, so the proposed regulations still don't resolve questions about the eligibility of internal-use software for the research credit.

Case law on the treatment of internal-use software under section 41 is limited. However, two recent cases--Norwest v. Commissioner [110 T.C. 454 (1998)] and United Stationers, Inc. v. U.S. [982 F. Supp. 1279 (N.D. Ill. 1997), on appeal (7th Cir., Dec. 23, 1997)]--provide insight into how the courts qualify internal-use software for the research credit, based on statutory and regulatory requirements. These cases (particularly Norwest, because of its extensive analysis), administrative rulings and the credit's legislative history give CPAs some insight into how these rules are applied, which is critical given the explosive growth of software development today. …

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