Computer software and the R & E credit.

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 software is used in (1) qualified research (other than the development of the internal-use software itself) undertaken by the taxpayer, or (21 a production process that meets the requirements for the credit (e.g., where the taxpayer is developing robotics and software for the robotics for use in operating a manufacturing process, and the taxpayer's research costs of developing the robotics are eligible for the credit). Any other research activities with respect to internal-use software are ineligible for the credit except to the extent provided in Treasury regulations. Accordingly, the costs of developing software are not eligible for the credit where the software is used internally, for example, in general and administrative functions (such as payroll, bookkeeping, or personnel management) or in providing non-computer services (such as accounting, consulting, or banking services), except to the extent permitted by Treasury regulations.

The committee report goes on and confuses the area by stating:

The specific rule in the conference agreement relating to internal-use computer software is not intended to apply to the development costs of a new or improved package of software and hardware developed together by the taxpayer as a single product of which the software is an integral part, that is used directly by the taxpayer in providing technological services in its trade or business to customers. For example, the specific rule would not apply where a taxpayer develops together a new or improved high technology medical or industrial instrument containing software that processes and displays data received by the instrument, or where a telecommunications company develops a package of new or improved switching equipment plus software to operate the switches. In these cases, eligibility for the incremental research tax credit is to be determined by examining the combined hardware-software product as a single product, and thus the specific rule applicable to internal-use computer software would not apply to the combined hardware-software product.

The distinction between internal-use software and a combined hardware-software product may become difficult to interpret in practice. Taxpayers wishing to be aggressive should try to build a case that they are developing a combined hardware-software product, not just software.

Software developed for resale apparently is eligible for the credit, since it is not developed primarily for internal use. Again, taxpayers that develop software to meet an internal need may try to market and sell the software to other businesses. Aggressive taxpayers may want to set up a separate company to develop the software and then sell it to their operating company and to unrelated third parties.

In conclusion, it appears as though there are four situations in which the costs of computer software will be eligible for the R&E credit:

1. Software developed for use in qualifying research.

2. Software developed for use in a qualifying production process.

3. Software developed as part of a combined hardware-software product.

4. Software developed for sale to third parties.