In October 2016, the U.S Department of the Treasury released new regulations providing more clarity on the definition of Internal Use Software (IUS). As a result, companies learned that more of their software development initiatives were eligible for the R&D Tax Credit. And they weren’t just commercial software vendors, either. Companies from a variety of industries took advantage of the new regulations.
Time spent improving upon or building Internal Use Software can count as qualified activities for the R&D Tax Credit. In this guide, we’ll explore the following areas regarding IUS:
- Introduction to IUS and the R&D Tax Credit
- Types of Internal Use Software
- IUS activities related to the R&D Tax Credit
- Tests to know if your activities qualify
Treasury Decision 9786 and Internal Use Software
Passed by the U.S. Department of the Treasury in 2016, Treasury Decision 9786 was intended to help clarify the many issues relating to internal-use software (IUS) and research activities that qualify for the R&D Tax Credit.
Thanks to TD 9786, the IRS considers software enabling a company to interact with third parties or that allows third parties to initiate functions or review data on that organization’s system to be IUS, providing another avenue for businesses to earn the R&D Tax Credit.
Types of Internal Use Software
As it applies to the R&D Tax Credit, there are several forms of IUS that could qualify. Before disqualifying yourself because your company doesn’t create software as its sole purpose, check the qualifying functions below:
- 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 good 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 sell or market to third parties.
IUS Activities Related to the R&D Tax Credit
Now that you know what types of software qualifies as Internal Use Software as far as the R&D Tax Credit is concerned, it’s time to explain just what qualifies for the R&D Tax Credit. In the case of IUS, what qualifies is your time spent either (A) Creating IUS or (B) Improving on IUS.
Creating Internal Use Software
If you’re building proprietary software to be used for internal use, there are a lot of qualifying activities. This process typically involves translating the requirements and specifications developed to date into code within the required technical environment to ensure the user and business needs are met. After the coding, QA and testing is conducted. In addition to all the core technical, development / coding related activities, here are a few 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 Software for Internal Use
In order for purchased software to qualify for the R&D Tax Credit as Internal Use Software, 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.
How to Know if Your Activities Qualify
If you have been spending time improving or creating software that you think could be defined as Internal Use Software, then you have one final step to confirm if it qualifies for the R&D Tax Credit: You need to not only pass the Four-Part Test (see below) but the 3-Part High Threshold of Innovation Test, too.
3-Part High Threshold of Innovation
The 3-Part High Threshold of Innovation Test regulations are:
- 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).
These regulations are designed to encourage companies in all industries to continue to invest in “software innovation” that allows them to compete more effectively on a global basis.
Understanding how IUS applies to the R&D Tax Credit can mean more money for your business. If you’re not sure where to start, or still have questions, we’re here to help. We’ve helped individual businesses each find millions of dollars in the form of R&D Tax Credits due to activities related to Internal Use Software development and enhancement. Time spent by staff working with us often translates to thousands of tax dollars saved for every hour the team spends. You may be surprised to learn what we could find in your business!