Internal Use Software ("IUS") and the R&D Credit
How we typically address IUS
To be considered a qualified research activity eligible for the research credit, the development of software created by (or for the benefit of) the taxpayer primarily for the taxpayer's internal use must satisfy the three-prong, high-threshold-of-innovation test in addition to the standard four-part test. Whether software will be considered to be developed primarily for internal use depends on the intent of the taxpayer and the facts and circumstances at the beginning of software development.
What is the High-threshold-of-innovation test
Software that does not meet the definition of software not for internal use under Regs. Sec. 1.41-4(c)(6)(iv) or does not fall under one of the exemptions listed in Regs. Sec. 1.41-4(c)(6)(ii) must meet the high-threshold-of-innovation test (Regs. Sec. 1.41-4(c)(6)(i)(C)). The high-threshold-of-innovation test is defined in Regs. Sec. 1.41-4(c)(6)(vii) and has three parts:
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;
The software development has significant economic risk in 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
The software is not commercially available, i.e., cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant economic risk requirements.
It is important to note that this regulation also provides that substantial uncertainty for purposes of the significant economic risk test requires a higher level of uncertainty and technical risk than required for business components that are not internal-use software. There are also special rules around the construct of what is deemed “dual-function software” where some aspects are IUS and some are not. We do not cover that topic in this article.
Given the high bar for any IUS project to qualify, we are generally avoiding qualifying any IUS projects unless the taxpayer is highly confident the project would meet the much more stringent qualification requirements. As such, when we are helping the taxpayer to identify potentially qualifying business components, we have the taxpayer categorize all projects as either IUS, non-IUS, or dual-function. To the extent any project is included and labeled as IUS or dual-function, we then work with the taxpayer to also apply three additional tests (collectively referred to as the "High-threshold-of-innovation test") to ensure the taxpayer is confident they will be able to demonstrate this much higher threshold of innovation.
It is also important to note what is Not IUS
The following types of internal-use software are not required to satisfy the high-threshold-of-innovation test:
Software for use in an activity that constitutes qualified research;
Software for use in a production process; or
Software that is an integral part of a new or improved hardware and software package developed together by the taxpayer as a single product (or the costs to modify an acquired software and hardware package), of which the software is an integral part, used by the taxpayer in providing services in its trade or business (Regs. Sec. 1.41-4(c)(6)(ii)).
Software is developed by (or for the benefit of) the taxpayer primarily for internal use if the taxpayer develops the software for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business. The final regulations limit general and administrative functions to:
Financial management functions,
Human resource management functions, and
Support service functions that support day-to-day operations such as data processing or facilities services (Regs. Sec. 1.41-4(c)(6)(iii)).
Non-internal-use software for purposes of Sec. 41
Regs. Sec. 1.41-4(c)(6)(iv) clarifies and expands the exceptions to the definition of internal-use software by providing that software is not developed primarily for internal use by the taxpayer if it is not developed for use in general and administrative functions that facilitate or support the conduct of a taxpayer's trade or business. The final regulations provide two specific examples of software that is not internal-use software under this rule:
Software developed to be sold, leased, licensed, or otherwise marketed to third parties; and
Software developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system.
The development of such software may be eligible for the Sec. 41 research credit if the development activities satisfy the four-part test under Sec. 41(d).
