Narrowed “internal use software” definition is good news for many

Historically, it’s been difficult for internal use software (IUS) to meet the stringent criteria to qualify for a research and development (R&D) tax credit. That hasn’t changed.

Back in January, however, the IRS released guidance that narrowed the definition of what’s considered to be IUS. This will likely have a positive impact on taxpayers looking to claim the R&D credit related to their software development activities.

A quick refresher on the R&D credit

To qualify for the R&D credit, an activity must meet four criteria:

• It must relate to a new or improved product or process intended to improve function, performance, reliability, or quality.
• It must be intended to discover information that eliminates uncertainty related to the capability, method, or appropriate design of a product or process.
• It must fundamentally rely on engineering, physical, biological, or computer science.
• The activities must undergo a process of experimentation such as testing, evaluation of alternatives, simulations, and developing prototypes.

Software considered to be IUS must meet all of these criteria plus all of these higher threshold requirements to qualify for the credit:

• Reduction in cost or a measurable improvement that’s substantial and economically significant.
• Commit substantial resources to the development and have substantial technical risk.
• Cannot be purchased, leased, or licensed and used for the intended purpose without modifications.

That’s a tall order. No wonder IUS rarely qualifies.

But IUS no longer includes…

The new rules expand the definition of software to say that software “sold, leased, licensed, or otherwise marketed to third parties” is not considered IUS. They go on to exclude software that enables the business “to interact with third parties.” Examples may include software developed to execute mortgage loans, purchasing tickets for entertainment, and customer tracking the delivery of goods. This narrower definition allows items formerly considered IUS to qualify more easily for the R&D credit.

So what is IUS?

The new rules provide some clarification around what types of software should be classified as IUS by stating that the designation should apply to software developed “for use in general and administrative functions,” such as financial management, human resources, and support services that target the back-office functions necessary for nearly every organization to operate.

In conclusion

These new rules will have a positive outlook for many businesses. To learn more about the IUS regulations, check out our recent webinar, "Sharpen Your Focus on Internal Use Software R&D Regulations" >>