Tax Aspects of Computer Software Development
| Publication year | 1984 |
| Pages | 959 |
1984, June, Pg. 959. Tax Aspects of Computer Software Development
In recent years, the computer software industry has been in a state of constant growth and, not surprisingly, is drawing a lot of research attention. Although software companies continue to emerge, entry into and success in the business may require large amounts of capital needed for the research and development of new products.
As the "high tech" boom continues in Colorado, it can be expected that a number of companies will use research and development ("R&D") partnerships to finance the development of new products. The R&D partnership is especially attractive because (1) various provisions of the Internal Revenue Code ("Code") create tax incentives which encourage investment in R&D projects; and (2) the use of the partnership form permits these tax incentives to be passed through to the investors, in turn permitting the investors to shelter other income.
One type of R&D partnership is a partnership formed to develop computer software. The structure of a typical software R&D partnership follows a model common to R&D partnerships formed to develop other products. However, due to the difficulty of conceptualizing computer software for income tax purposes and the changing treatment of software under patent and copyright law, the software R&D partnership presents special problems which require extensive tax planning. This article discusses planning the R&D partnership by focusing on partnerships formed to develop computer software.
A simple and common structure for the R&D partnership involves two entities, a corporation and a limited partnership. The partnership is composed of limited partners who contribute the capital necessary to finance the R&D project and one or more general partners. The corporation wears a number of hats: it or a related entity performs the research project on behalf of the partnership and, after the development is completed, has an option to acquire from the partnership the exclusive right to manufacture and market products incorporating the technology developed. It or an affiliate may also be a general partner of the partnership. Until the purchase option is exercised, the technology is owned by the partnership and may be licensed to the corporation on a nonexclusive basis.
A number of contracts are required in addition to the limited partnership agreement. First, the partnership must enter into an R&D contract with the corporation whereby the corporation will use its best efforts to produce the technology on behalf of and at the risk of the partnership. Typically, the contract calls for immediate payment of a fixed fee (a "turnkey" contract) or for reimbursement of costs as they are incurred, plus a percentage of those costs.
The R&D contract also provides that the corporation will use partnership payments in a manner which will constitute research or experimental expenditures that may be passed through to the partners and deducted pursuant to Internal Revenue Code ("IRC") § 174. Since the research must be undertaken at the partnership's risk in order to qualify for the IRC § 174 deduction, the R&D contract should contain no guarantee of success.
Second, to the extent that the research project requires the use of existing technology developed by the corporation, the corporation should enter a licensing agreement to permit the partnership to use the technology.
Third, the partnership should grant the corporation an option to purchase the technology. Because one of the goals of the partnership is to obtain long-term capital gains treatment on the sale of the technology, the purchase option should be exercisable only after the expiration of one year after the technology is "reduced to actual practice," unless it covers technology which is patented or patentable and which qualifies for capital gains treatment pursuant to IRC § 1235 (see below). Payment for the technology may take the form of a lump sum, royalties, installment payments or an issuance of corporate stock to the partnership followed by a dissolution of the partnership. The purchase option must be a "true" option and leave the risk of nondevelopment or unsuccessful development of
the technology on the partnership.
Finally, since the corporation typically desires to exploit the technology before it exercises its option, there may be a license agreement by which the partnership gives the corporation a nonexclusive license to manufacture and sell products incorporating the technology.
While there may be variations in the parties to and terms of the agreements, the R&D partnership usually follows this rather simple structure.
The R&D partnership is inspired by tax subsidies designed to encourage innovation, and since it a creation of the Internal Revenue Code, comprehension of a number of relatively complex tax provisions is essential. The tax incentives are contained in three sections of the Code: (1) IRC § 174, providing that research or experimental expenditures may be deducted in the year paid or incurred; (2) IRC § 44F, providing a tax credit for increased research activities; and (3) IRC § 1235, providing special rules for obtaining long-term capital gain treatment on income derived from the sale or licensing of patents or patentable inventions.
In addition, other provisions of the Code, which are not special to R&D activities, are applicable to R&D partnerships. These include Subchapter K, dealing with the taxation of partnerships (not discussed in this article) and IRC §§ 1221 and 1231, dealing with the sale or exchange of capital assets or other business assets.
The goal of the R&D partnership is to provide large deductions to the limited partners in the taxable year of their investment and long-term capital gains on the sale of the technology developed.
The primary tax subsidy for R&D projects can be found in IRC § 174(a), which provides for the deductibility of research and experimental expenditures:
A taxpayer may treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account. The expenditures so treated shall be allowed as a deduction.
To qualify for IRC § 174 treatment, expenditures must be (1) "research or experimental expenditures," and (2) paid or incurred in connection with the taxpayer's trade or business.
Third, the partnership should grant theIRC § 174 does not define "research or experimental expenditures," but the Treasury Regulations state that the term means "expenditures incurred in connection with the taxpayer's trade or business which represent research and development costs in the experimental or laboratory sense."(fn1) Examples of research or experimental expenditures include costs incident to the development or improvement of a model, plant process, product, formula or an invention.
There is a dearth of precedent concerning what constitutes a research or experimental expenditure, and decisions as to whether a particular expenditure qualifies must be made on a case-by-case basis. The purpose of the § 174 subsidy should be considered in making such determinations---the deduction was created to encourage expenditures which foster innovation. Thus, costs incurred in the development of new techniques and new products typically should be entitled to § 174 treatment.
The question of what constitutes a research or experimental expenditure in the area of computer software development is currently at issue. In January 1983, the IRS published a proposed amendment to § 1.174-2 of the Treasury Regulations which appeared to discriminate against software expenditures and drew a lot of criticism. Proposed Regulation § 1.174-2(a)(3) states:
Generally, the costs of developing computer software are not research or experimental expenditures within the meaning of section 174. However, the term "research or experimental expenditures," as used in section 174, includes the programming costs paid or incurred for new or significantly improved computer software. The term does not include costs paid or incurred for the development of software the operational feasibility of which is not seriously in doubt.... Whether software is "new or significantly improved" will be determined with regard to the computer program itself rather than the end use of the program. (Emphasis added.)
To understand the proposed amendment to the § 174 regulations and the criticism it engendered, it is first necessary to consider the background from which the controversy arose.
There is no case law applying IRC § 174 to computer software R&D partnerships. That precedent which does exist arises from Rev. Proc. 69-21, in which the IRS stated that the cost of developing software so closely resembles research and experimental expenditures which do qualify for the § 174 deduction that they should be similarly treated.(fn2) Therefore, Rev. Proc. 69-21 does not say that software R&D expenditures constitute § 174 expenditures; rather, it provides that they will be treated under similar rules.
Moreover, Rev. Proc. 69-21 does not on its face distinguish between the development of innovative software in which there is considerable risk and the modification of existing software or existing techniques where there is little or no risk. It speaks of software in generic terms and, in doing so...
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