Internal-use software and the research credit.

Taxpayers who claim the incremental research credit, particularly for internal-use software, must meet a new "discovery" test. In United Stationers, Inc. v. United States (no. 92 C 6065, N.D. Ill., October 17, 1997), an office products wholesaler was denied the research credit for internal-use software in part because its projects did not discover any technological information, venture into new fields or develop a new realm of computer science.

United Stationers had developed the software to automate certain business operations, including document management, order processing and invoicing, marketing and inventory control. The court considered whether

* United Stationers undertook the software projects to discover information that was "technological in nature."

* Substantially all the research activities constituted elements of a process of experimentation.

* The projects involved internal-use software.

* The software was innovative.

* The projects involved significant economic risk.

Judge Norgle, emphasizing the discovery element of the technology test, concluded there was no evidence United Stationers had discovered any information of a technological nature or even intended to expand or refine existing principles of computer science. According to Norgle, United Stationers had "merely applied, modified and, at most, built upon preexisting technological information." Further, he said the projects lacked an essential element of an experimental process--some degree of technological uncertainty at the outset about whether the programs would work--as contrasted with whether they would produce the anticipated economic benefits.

The judge also concluded United Stationers developed the software primarily for its own use. Although he considered the software "innovative," Norgle held the projects did not involve the necessary economic risk to claim the credit--based on internal technological risks, not the amount of money United Stationers had devoted to the project.

Observation. The decision will influence the outcome of many research credit claims currently before the IRS and may create in ore hurdles taxpayers must overcome in supporting their claims. Further, companies that implement integrated manufacturing and other enterprisewide computer systems believe some of the costs of those systems, particularly when they entail process reengineering, should qualify for a research credit. The IRS, however, is expected to actively challenge such claims, taking full advantage of the United Stationers decision.

Taxpayers should distinguish their software development from the mere adaptation that the court seemed to find in United Stationers and be able to demonstrate technical as well as economic risk. Some may be able to establish that their internal-use software is part of a process that is considered qualified research. Others may need to establish that the software development ventured into an uncertain field or provided technology to use computers in a manner that was never before available.

--Tracy Hollingsworth, Esq., staff director of tax councils at Manufacturers Alliance, Arlington, Virginia.