Eligibility of internal-use software for research credit needs clarification.

• Author: Auchincloss, Louis

Prop. Regs. Sec. 1.41-4, released Dec. 31, 1996, addresses the Tax Reform Act of 1986 (TRA '86) provision on eligibility of internal-use software for the research credit. The proposed regulations generally track the legislative history underlying Sec. 41(d)(4)(E), with little elaboration. In the absence of further guidance, a recent U.S. magistrate's opinion used a questionable reading of the legislative history to deny the credit for costs of developing software to automate and computerize a wholesaler's business operations (United Stationers, DC Ill., 3/18/97). Regardless of the final outcome of this case, it indicates that some IRS agents have a very restricted view of the circumstances under which internal-use software development costs can qualify for the credit.

The taxpayer in United Stationers, the nation's largest independent office products wholesaler, had been unable to satisfy customer demand after a rapid growth rate in annual sales. The taxpayer developed seven software programs to increase its business efficiency and claimed a research credit of $156,000. The programs were designed for document retention and retrieval, centralized invoicing, marketing, computer-to-computer order entry, inventory maintenance, shipment processing, and inventory forecasting and replenishment. All of these functions, not previously automated, enabled the taxpayer to manage its growing customer demand so that the business process add workflow efficiency improved markedly.

In denying credit eligibility, the magistrate's opinion quoted extensively from the legislative history of the TRA '86, stating that the scope and applicability of the credit "remain ambiguous" and that there is "very little case law even discussing the issues." Turning first to the general "technological in nature" requirement for the credit, the magistrate virtually ruled out eligibility for internal-use software, writing that the credit is limited to "widely applicable, high technology advancements" that benefit "aspects of the country's economy." The magistrate found that "merely adding a new program to a computer so that it becomes a more efficient tool for a particular business" does not meet the test. The TRA '86 legislative history, however, stated that research that "fundamentally relies" on principles of computer science satisfies the "technological in nature" test; there is no requirement that the taxpayer produce "widely applicable" advancements enhancing other...