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New proposed regulations for internal use software

On Jan. 16, 2015, the IRS released proposed regulations under section 41 of the Internal Revenue Code (IRC) related to software development that revise the scope of the exclusion for internal use software (IUS), define IUS, and clarify what is not IUS.

Why is this important?

Section 41 of the IRC provides a general exclusion of IUS from the R&D credit. However, under prior regulations, IUS was not specifically defined; rather, software was deemed to be IUS if it was not developed to be commercially sold, leased, licensed, or otherwise marketed to third parties.

The proposed regulations provide the following important modifications related to IUS:

  • IUS is defined under the proposed regulations as software used for “general and administrative” functions that facilitate or support the conduct of the taxpayer’s trade or business. General and administrative functions are limited to “back-office” functions such as financial and human resource management and support services functions.
  • Consistent with prior regulations, the proposed regulations provide that software is not IUS if it is developed to be commercially sold, leased, licensed, or otherwise marketed to third parties. However, the proposed regulations further provide that software developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system is also not IUS.
  • IUS software can still qualify for the R&D credit if it meets the high threshold of innovation test—i.e., the software must be innovative; the software must involve significant economic risk; and the software must not be commercially available to the taxpayer. This is consistent with the prior regulations. However, the proposed regulations apply more reasonable criteria as it relates to the application of the innovation component of the high threshold of innovation test.

Why does it mean for you?

The new proposed regulations related to software development pave the way for more companies to take advantage of the R&D credit. The regulations are proposed to apply to tax years ending on or after the date of publication as the final regulations. However, the IRS will not challenge return positions consistent with the proposed regulations for tax years ending on or after Jan. 19, 2015.

If your company is incurring costs to develop software platforms, programs, systems, or applications, it’s important to consider potential R&D credit opportunities, especially in light of the new proposed regulations.

For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

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