Some internal-use software qualifies for research and development credit.

• Author: Nevius, Alistair M.

Taxpayers that develop software for their own internal use will be able to claim a credit for research and development expenditures in some cases under final regulations issued by the IRS on Oct. 3 (T.D. 9786). The rules finalize, with some changes, regulations that were proposed in January 2015 (REG-153656-03).

The general rule is that internal-use software--software developed by (or for the benefit of) the taxpayer primarily for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business--does not qualify for the Sec. 41 research credit. The regulations provide an exception if the software's development meets a high-threshold-of-innovation test.

General and Administrative Functions

The regulations' definition of "general and administrative functions" remains unchanged from the proposed regulations despite some commenters' concerns that the fist was overly broad and would encompass some functions that are not "back office" functions. The IRS, however, stuck with its original definition, which encompasses (1) financial management functions (i.e., functions that involve the financial management of the taxpayer and supporting recordkeeping); (2) human resource management functions (i.e., functions that manage the taxpayer's workforce); and (3) support service functions that support the taxpayer's day-to-day operations (such as data processing).

The preamble to the regulations notes that software that is not developed to be used for general administrative functions is not considered to be developed for internal use, even if the software is not developed to be sold, leased, licensed, or otherwise marketed to third parties and is not developed to enable the taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system.

Dual-Function Software

Software that serves both general and administrative functions and other functions (called dual-function software) must overcome a presumption that it is developed for internal use and thus does not qualify for the credit. The presumption will not apply if the taxpayer "can identify a subset of elements of dual function software that only enables a taxpayer to interact with third parties or allows...