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Abstract: 

Taxpayers were pleasantly surprised in early 2015 when the Treasury/IRS issued proposed regulations relating to the treatment of software development under the Section 41 Research Credit. Financial institutions were particularly interested in the changes made to the definition of Internal-Use Software (IUS) development and the related qualification requirements. Since most of their software development had been classified as IUS in the past, and the challenge of proving credit eligibility for IUS development was so difficult, financial institutions have long suffered an uphill battle to secure this incentive. Although the proposed rules appeared very favorable, and would likely allow credit eligibility to most customer-facing type application development that financial institutions are currently developing, some of the proposed provisions likely would cause significant confusion not only for taxpayers but for the IRS as well—and thus certainly result in future tax controversy. As this article details, the final regulations issued in October 2016 have revised the proposed rules, making significant favorable changes and providing much greater clarity.

Keywords: R&D credit, IRC Sec. 41, internal use software, High Threshold of Innovation Test, dual-function software

Affiliations:  1: Tax Credits Group.