Software enhancements lacked requisite innovation and scientific experimentation for R&D credit.

• Author: O'Driscoll, David
• Position: Reseach and development

P, an S corporation, develops and sells software that independent insurance agencies use to manage their businesses. During the early 1990s, P improved its software package;its investors (KA) wanted to take a Sec. 41 tax credit based on the amount by which P increased its research and development (R&D) expenses during those years. KA had sought a Sec. 41 credit for commercial software development before and was unsuccessful; see Tax and Accounting Software Corp., 301 F3d 1254 (10th Cir. 2002), cert. den.; Wicor, Inc., 263 F3d 659 (7th Cir. 2001); United Stationers, Inc., 163 F3d 440 (7th Cir. 1998); and Norwest Corp., 110 TC 454 (1998).The only exception--on which the taxpayers in this case principally rely--is the district court's decision in Tax and Accounting Software Corp., 111 FSupp2d 1153 (ND OK 2000), which the Tenth Circuit reversed after the taxpayers filed their brief.

P's Development Activity

During the early 1990s, P enhanced its software package, so that:

* It could handle additional ratings computations;

* It could handle transactions between insurers and agencies;

* Multiple individuals could work on the same customer file simultaneously without corrupting or overwriting each others' changes; and

* It could handle more functions in a given amount of random access memory (RAM).

P discarded a word processing module licensed from another vendor, replacing it with a simple text editor with reduced memory demands, but good form-letter-generation features. These were not the only changes, but they show the character of the work. None of it was pioneering; all of it entailed variations on themes long used by other developers.

Research and Experimentation Requirements

The Service contested whether P's activities met several Sec. 41 requirements, including that the (1) research be "undertaken for the purpose of discovering information which is technological in nature" (Sec. 41(d)(1)(B)(i)) and (2) activities "constitute elements of a process of experimentation" (Sec. 41(d)(1)(C)) . The Tax Court had concluded that P failed both tests--the former because it did not produce an "innovation in underlying principle" and the latter, because the research in question was not designed to dispel uncertainty about the technological possibility of developing such software.

P has not tried to show that its software embodies any leap in information technology or that there was any doubt about the technological ability to produce software of this...