Even though the definition of “Internal Use Software (IUS)” was more clearly defined nearly four years ago (October 2016, U.S. Department of the Treasury), confusion remains regarding what software development initiatives are eligible for the R&D Tax Credit.
Initially, the new regulations were a boon for commercial software vendors, yet companies from a variety of industries (you don’t need to be a commercial software vendor!) can take advantage, too. In fact, nearly any time spent improving upon or building Internal Use Software can count as qualified activities for the R&D Tax Credit.
In this article, we’ll answer the following common questions regarding IUS:
- What’s the latest on IUS and the R&D Tax Credit?
- What are the types of IUS?
- What IUS activities qualify for the R&D Tax Credit?
- Are there tests to determine which activities qualify?
What’s the latest on IUS and the R&D Tax Credit?
As previously mentioned, 2016’s Treasury Decision 9786 was intended to help clarify the many issues relating to Internal Use Software (IUS); specifically, which research activities qualify for the R&D Tax Credit.
The IRS now considers these to be IUS:
- Software enabling a company to interact with third parties
- Software allowing third parties to initiate functions or review data on that organization’s system
So software developed for the delivery of service — providing an application for customers to look up financial information at a bank/brokerage firm, purchase a product online, check the status of an order, or accept customer payments — can now be included in the R&D Tax Credit.
What are the types of IUS?
This is important! Don’t disqualify yourself because your company doesn’t market software to third parties.
Still with us? Good. As it applies to the R&D Tax Credit, there are several forms of IUS that could qualify. Here are the qualifying functions:
- Financial management functions of the taxpayer and the supporting record keeping
- Human resource management functions that manage the taxpayer’s workforce
- Support services functions that support the day-to-day operations of the taxpayer
Another form of IUS that qualifies for the R&D Tax Credit is Dual Use Software. Simply put, Dual Use Software is software that helps organizations not only internally but their customers as well.
One example of Dual Use Software is banking software. These platforms were developed specifically to make it easier for customers to do business with their banks — moving money from one account to another, checking balances, depositing checks, etc. So while the software is not strictly internally facing, it’s also not developed to be marketed to third parties.
What IUS activities qualify for the R&D Tax Credit?
Now that you know what types of software qualifies as IUS as far as the R&D Tax Credit is concerned, it’s time to explain just what activities qualify for the R&D Tax Credit. In the case of IUS, it comes down to the time spent either A) creating IUS or B) improving IUS.
Creating Internal Use Software
If you’re building proprietary software for internal use, there are many qualifying activities. This process typically involves gathering requirements and translating those requirements and specifications into code within the required technical environment to ensure the user and business needs are met.
After the coding, quality assurance and testing are conducted. In addition to all the core technical, development, and coding related activities, there are other activities that usually qualify:
- Developing/documenting test and user acceptance criteria
- Iterative process of testing and updating code to achieve the desired result
- Technical, environmental, system, and program documentation
- Supervisors/managers time involved in leading, directing, and coaching the staff performing qualifying activities
Improving on Purchased Internal Use Software
We’re often asked, “Can I include the cost of my CAD software subscriptions in R&D?” In order for purchased software to qualify for the R&D Tax Credit as IUS, your company must have spent time and other resources making modifications or improvements to it to suit your organization’s needs. It can’t have just been bought and used as is.
With that in mind, the same types of activities qualify for improving IUS as they do for creating IUS.
Are there tests to determine which activities qualify?
Have you been spending time improving or creating software that you think could be defined as IUS? There are two tests — the 3-Part High Threshold of Innovation Test and the Four-Part Test — to help you confirm if Internal Use Software qualifies for the R&D Tax Credit.
3-Part High Threshold of Innovation Test
- The software results in cost reduction, improved speed, or other measurable improvement that is substantial and economically significant.
- The software development process involves significant economic risk. This means that the taxpayer commits substantial resources to the development, and there is uncertainty due to technical risk that the resources would not be recovered within a reasonable period of time.
- The software is not available to be purchased, leased, or licensed in the commercial market and is used for the intended purpose without modifications required to satisfy the innovation and significant economic risk requirements above.
- Permitted Purpose. This is the activity intended to make or improve either a product or process that results in improved function, performance, reliability, quality or cost efficiency.
- Technical Uncertainty. This is the activity intended to eliminate technical uncertainty when developing or improving a product or process related to methodology, design, techniques, formulas or inventions.
- Process of Experimentation. This is the activity that includes a process of experimentation to eliminate or resolve technical uncertainty. During the process, various alternatives and approaches are evaluated by modeling, simulation, trial and error, prototyping and other methods.
- Technological in Nature. The process of experimentation must rely on the hard sciences (engineering, physics, biology, chemistry, computer science).
As you’ve seen, understanding how Internal Use Software applies to the R&D Tax Credit can mean more money for your business. Some have found millions of dollars in the form of R&D Tax Credits due to activities related to IUS development and enhancement. Yet, getting started can seem like the toughest part.
At Black Line Group, we’ve helped many businesses like yours. The time spent by your staff working with us often translates to thousands of tax dollars saved for every hour the team invests. You may be surprised to learn what we could find in your business.