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

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 kind. It contends that Sec. 41 does not set so high a standard and that the industrious development of software through a process of trial and error meets the statutory standard. However, United Stationers held that software development satisfies the statutory technological-information requirement only if "the research is intended to expand or refine existing principles of computer science" and the resulting information is "of broad effect." As for experimentation, we held that the taxpayer must formulate and test hypotheses to dissipate uncertainty about the possibility of success, a standard that fine-tuning (or debugging) of computer programs does not satisfy.

The word "experiment" as used in Sec. 41, has the scientific sense of forming and testing hypotheses, rather than the lay (or even engineering) sense of trial and error. For example, an automobile manufacturer trying different nozzles from those on hand to find the one that applies the smoothest coat of paint is not engaged in "experimentation" under this view, nor is a software developer trying different methods to implement a feature accompanied by maximum execution speed and minimum demand on system resources, such as RAM.

Authors and movie makers playing with sentences and scenes to find those that most impress the public are not doing scientific research using "experimentation" Developers are authors too; because they write machine readable code rather than lines of words readable by people, does not fundamentally change the nature of the task and make one form of writing "experimentation," when the other is not. Experimentation is a subset of all steps taken to resolve uncertainty; otherwise, searching for a place to park a car would be a "process of experimentation" The Tenth Circuit has disagreed with our understanding of Sec. 41. It held in Tax and Accounting Software that the technological-information requirement can be satisfied by new knowledge that is less a step forward than United Stationers required--but that "information must be separate from the product that is actually developed."

As to experimentation, it was not receptive to the idea that only hypothesis formulation and testing fits, but it still held that the taxpayer must establish that testing was designed to overcome uncertainty about whether the desired end result was technologically feasible. P cannot meet these definitions any more than those in United Stationers.

Both United Stationers and Tax and Accounting Software analyzed Sec. 41 without the benefit of the regulations that are supposed to illuminate the path to a decision. The most recent proposed amendments have not been made final (REG-112991-01). However, they state that the final regulations will apply only to tax years ending after Dec. 25, 2001. In any case, the regulations essentially track United Stationers' definition of "experimentation" as use of the scientific method.

P argues that Wicor and United Stationers should be disregarded on the ground that the credit sought by those taxpayers was covered by Sec. 41(d)(4)(E), which disqualifies the costs of internal-use software except to the extent allowed by (nonexistent) regulations. In both Wicor and United Stationers, the taxpayer contracted with a consulting firm to develop software to use in its own business, while P developed software for sale to customers. Yet Sec. 41(d)(4)(E) has nothing to do with the definitions in Sec. 41 (d)(1), and Wicor stopped there. United Stationers held that the taxpayer lost under both Sec. 41(d)(1) and (d)(4)(E). Secs. 41(d)(1) and (d)(4) are independent rules, which deserve, and have received, independent constructions. Under either the definitions articulated in United Stationers or the competing interpretation from Tax and Accounting Software, simple industrious software development does not qualify for the Sec. 41 credit.

For further discussion of the R&D credit for internal-use software, see Witner and Krumwiede, "Purchasing, Leasing and Developing Software (Part II), p. 486, this issue.

Nicholas Eustace, 312 F3d 905 (7th Cir. 2002), cert. den.