Computer software and the R & E credit.

• Author: Baptiste, Phillip J.
• Position: Research and experimentation

Businesses are continually finding new ways to use computers in their operations. Today, software can be purchased that accomplishes many functions. However, many businesses still find it necessary to develop software in-house to do certain tasks. When a business develops software internally, the question is whether the development qualifies for the research and experimentation (R&E) credit.

Sec. 41 provides a credit of 20% of excess qualified research expenses. Qualified research expenses are wages and supplies used in conducting qualified research. Qualified research must meet the following criteria:

1. Expenditures must be treated as an expense under Sec. 174.

2. The purpose of the research must be to discover information that is technological in nature.

3. The application of the research must be intended to be useful in the development of a new or improved business component of the taxpayer.

4. Substantially all the research activities must constitute elements of a process of experimentation.

   Qualifying under Sec. 174 as an R&E expense is critical to eligibility for the Sec. 41 credit. Sec. 174 allows taxpayers to deduct as current expenses the costs of qualifying research. The IRS has had a difficult time dealing with internally developed software under Sec. 174. initially, the Service treated software development just like any other product development. However, proposed regulations under Sec. 174 required software to meet a higher standard than ordinary product development. In the latest proposed regulations, the IRS is back to treating software like any other product development.

   Currently under Sec. 174, most significant internally developed software projects would appear to be eligible for the R&E credit. However, there is one final hurdle that software must overcome to be eligible. Sec. 41(d)(4)(e) provides that computer software developed primarily for a taxpayer's own internal use is not eligible for the credit. There are two exceptions-software developed for use in qualifying research and software developed for use in a qualifying production process.

   The only guidance in determining if software development is subject to an exception or not is in the committee report to the Tax Reform Act of 1986:

   Under a specific rule in the conference agreement, research with respect to computer software that is developed by or for the benefit of the taxpayer primarily for the taxpayer's own internal use is eligible for the credit only if the...