Denial of research credit for computer software program costs.

The district court has decided United Stationers, DC Ill., 3/18/97, dealing with the application of the research credit provisions to the development of internal use software; it disallowed the company's research credit claim because the activities did not constitute a process of experimentation, were not technological in nature and did not represent a significant economic risk.

United Stationers is a leading supplier of office products. It developed eight different computer software programs dealing with individual functions, including paperless invoicing, inventory management, purchasing, online order processing, shipping and other internal functions, and claimed a refund due to research credits arising from the development of these programs.

United Stationers had argued that because the software involved in this case related to its core business of dealing with and delivering products to customers, it did not meet the definition of "internal use." Relying on examples in the committee report and the clear definition of the term, the court held that the software in question was clearly intended to be for internal use by United in its business. As a result, the taxpayer had to meet the additional requirements discussed in the Sec. 41 committee reports.

To qualify for the credit, the development of internal use software must meet the four general tests of Sec. 41 (d), as well as three additional tests under the legislative history to Sec. 41 (d)(4)(E). These tests, as well as the court's findings 011 the matters, are summarized in the chart below.

Looking to the legislative history of the research credit, the court noted that the term "process of experimentation" meant "a process...to design a business component where the design...is uncertain at the outset." The court noted that the only evidence submitted by the taxpayer in addressing the existence of any uncertainty involved concerns as to the potential business and financial benefits of the projects (e.g., whether there would be increased sales and ordering efficiencies from the use of the systems). Absent from the documents submitted was any description of the uncertainties surrounding the system's design that the company faced at the beginning of the project. These facts allowed the court to conclude that there was no process of experimentation; the company had documented no uncertainty as to its ability to design and implement the project.

One of the major stipulations in the case was the fact that the projects qualified under Sec. 174. Under Sec. 174, expenditures represent research costs in the laboratory sense if they are for activities intended to discover information that would eliminate uncertainty. As a result, the conclusion that there was no uncertainty as to the company's ability to develop and implement these projects seems to be inconsistent with the stipulated facts.

In ruling for the Service on this issue, the court agreed the project did not involve a significant economic risk because the ability to implement these projects was clear from the outset. The court recognized that the company had incurred an economic risk that the anticipated business benefits of the software would not materialize; however, the taxpayer had not demonstrated adequately the existence of technical risks associated with the project. This holding seems to be based 022 the analysis by the court of the "process of experimentation" issue and again seems to be inconsistent with the stipulation under Sec. 174.

The court held that the company's activities did not meet the requirement that the research be undertaken to discover information technological in nature. The court agreed that the company's projects can be considered technological in nature, but held that they did not "discover" new information. Rather, the court held that they merely applied, modified and (at most) built on preexisting technological information already supplied to it. The court cited TSR Inc., 96 TC 903 (1991), in which a taxpayer gathered preexisting information and incorporated it into a computer game.

FROM DAVID S. HUDSON, WASHINGTON, D.C.

Research Credit for Computer Software Program

                                             Court
                                             ruled for   Project
                                             taxpayer    qualified
                                  Court     (i.e.,       under
                                  ruled     project      joint
                                  for IRS   qualified)   stipulation

General tests under Sec. 41(d):

Qualify under Sec. 174                                        X
Process of experimentation           X
Technological in nature              X
Results in new business                                       X
 component

Additional test for internal
 use software:

Software is innovative                           X
Developmental activity involves
 significant economic risk           X
Software is not commercially
 available                                                    X