Software developed primarily for a taxpayer's internal use is subject to special federal rules under the R&D tax credit. Under the Treasury Regulations (§1.41-4(c)(6)), such software generally must satisfy not only the four-part test for qualified research but also an additional "high threshold of innovation" test. This page explains the framework in general terms. It is a nuanced area, and the analysis turns on the specific facts. This page is educational and is not individualized advice. For the underlying framework, see our page on the four-part test.
What Is Internal-Use Software?
Under the Treasury Regulations, software is developed primarily for a taxpayer's internal use if it is developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business. The regulations identify examples of general and administrative functions, including financial management, human-resources management, and support services. Software developed for these purposes is generally treated as internal-use. Whether software is internal-use is determined based on the taxpayer's intent and the facts and circumstances at the beginning of the development.
Why Internal-Use Software Receives Special Treatment
Congress and the Treasury determined that certain software developed for internal use should be subject to a higher standard, because some such development can resemble ordinary business modernization rather than the kind of research the credit is intended to recognize. The regulations therefore impose an additional test on internal-use software beyond the four-part test that applies to all qualified research.
The General Qualified-Research Requirements
Internal-use software must first satisfy the four-part test: a permitted purpose, technological in nature, elimination of uncertainty, and a process of experimentation, all with respect to a business component. There is no relaxation of these requirements for internal-use software. For more, see our pages on qualified research and the four-part test.
Additional Internal-Use Software Requirements
Under §1.41-4(c)(6), software developed by or for the benefit of the taxpayer primarily for the taxpayer's internal use is eligible for the credit only if it also satisfies the high threshold of innovation test. The regulations also address software developed for use in a production process and software that is an integral part of a hardware-and-software package developed together, which may be treated differently.
High Threshold of Innovation
The high threshold of innovation test, set out in §1.41-4(c)(6)(vii), generally requires that:
- the software is innovative — intended to result in a reduction in cost or improvement in speed or other measurable improvement that is substantial and economically significant if the development is or would be successful;
- the software development involves significant economic risk — the taxpayer commits substantial resources to the development and there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period; and
- the software is not commercially available for use by the taxpayer — it cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant-economic-risk requirements.
The implementation of existing technology by itself is not evidence of innovation, but the use of existing technology in new ways could be evidence of a high threshold of innovation if it resolves substantial uncertainty. Meeting this test is in addition to, not in place of, the four-part test.
Software That May Not Be Treated as Internal Use
Not all software is internal-use. The regulations provide that software is not developed primarily for internal use if it is not developed for general and administrative functions — for example, software developed to interact with third parties (such as customers or vendors), or to allow third parties to initiate functions or review data on the taxpayer's system. Software that is developed to be commercially sold, leased, licensed, or otherwise marketed to third parties for separately stated consideration is also not internal-use. Software used internally only for testing prior to commercial sale, lease, or license is not treated as internal-use solely for that reason. Software that is not internal-use is evaluated under the regular four-part test without the high-threshold requirement.
Dual-Function Software
Software developed both for general and administrative functions and to enable interaction with third parties (sometimes called dual-function software) is, under the regulations, generally presumed to be developed primarily for internal use unless an exception applies. The presumption can be rebutted under certain conditions described in the regulations, and the analysis depends on the specific facts. This is one of the more nuanced aspects of the internal-use-software rules.
Example Fact Patterns
The following are general illustrations drawn from the structure of the regulations; none automatically qualifies, and each depends on the specific facts:
- Software developed for a taxpayer's internal financial-management or human-resources functions is generally internal-use and must satisfy the high threshold of innovation.
- Software developed primarily to allow customers to interact with the taxpayer's system may not be internal-use and is evaluated under the regular four-part test.
- Software developed for use in a production process that meets the qualified-research requirements may be treated outside the internal-use framework.
- Software developed to be commercially sold or licensed to third parties is not internal-use.
These are illustrations of how the framework is applied, not conclusions about any particular taxpayer's software.
Documentation That May Help
Because the internal-use analysis is fact-intensive, records describing the software's intended use at the beginning of development, whether it was intended for general and administrative functions or to interact with third parties, the technical uncertainty, the alternatives evaluated, and the innovation and economic-risk considerations can help support the analysis. For more, see our page on R&D tax credit documentation.
Professional Review
The internal-use-software rules are detailed and fact-specific, and the high-threshold-of-innovation test is a demanding standard. Professional review is appropriate before claiming a credit for internal-use software. For more on software activities generally, see our page on software development and the R&D tax credit.
Key Takeaway
Software developed primarily for a taxpayer's internal use is subject to additional requirements beyond the four-part test, including a high threshold of innovation requiring innovation, significant economic risk, and that the software not be commercially available. Whether software is internal-use is a facts-and-circumstances determination, and software that interacts with third parties or is commercially sold may not be internal-use. Because these determinations are fact-specific, professional review is appropriate before claiming the credit.