The IRS recently finalized new regulations that could allow more businesses to take a R&D tax credit against the costs of developing software for internal use. In most cases, but not all, a tax credit is much more valuable than a tax deduction.
Internal use software is defined as software developed to support general and administrative functions, such as financial management, human resource management and support services such as data processing. This is particularly relevant to healthcare organizations and physician practice groups developing their own specialized EHR software rather than "purchased" software.
Before now, the wages, supplies and other expenses incurred to develop such internally used software did not qualify for R&D tax credits that were otherwise available for software that a company developed for sale or lease to third parties.
To use the credit against internal software development, the IRS regulations lay out a three-part, "High Threshold of Innovation" test.
The software must:
- Be highly innovative as defined in the regulations,
- Involve significant economic risk, and
- Those commercially available cannot meet your required needs to be compliant, so development was necessary.
The new regulations also clarified guidelines for businesses that develop new and improved software intended to be sold or used for third-party interactivity. For example, many companies develop third-party-facing software that a customer might access through the internet to transact business with a company. It was unclear if that software would qualify for R&D tax credits or would be considered internal use. Non-internal use software only needs to satisfy a standard four-part test, not the high-threshold test.
The regulations also allow taxpayers to use the R&D tax credit for qualified costs on software that has both internal use and non-internal use components. To take advantage of this, companies must quantify a subsection of the software system that enables interactions, functionalities and data revisions between the company and third parties.
Overall, the new regulations recognize the value of investing in technology and innovation, and provide a path for a company to reduce costs through tax credits.
In addition to the R&D tax credits, it is important to look at the possible deductions and tax benefits from recent equipment purchases for 2016 tax purposes. While an equipment tax credit has not been available for many years, there remains some depreciation alternatives on the cost of equipment that can be of value.
The PATH Act raised the limit for taking Section 179 Expense to $500,000 per tax year. Section 179 Expense allows a business to deduct the full purchase price of purchased equipment and qualifying off-the-shelf software. "Purchased" does not mean that taxpayers have to pay for the equipment with cash on-hand, but rather they can finance it with a loan or even a qualified leasing arrangement. The total cost of the equipment acquired must be within specified dollar limits of Section 179 (no more than $2 million of combined equipment/qualifying software purchases in a tax year to utilize the full $500,000 Section 179 Expense).
If a taxpayer acquires more than $2 million of equipment in a tax year, the $500,000 Section 179 limit is phased out on a dollar-for-dollar basis until the taxpayer reaches the $2.5 million threshold when it is phased out completely, and the taxpayer must rely on normal tax depreciation rules. Thus, it may become very important to properly plan your equipment purchases into separate tax years to fully utilize the Section 179 Expense benefits and the timing of the tax deductions that Section 179 creates.
The PATH Act also reinstated the 50 percent bonus depreciation on new equipment purchases, and also included escalators for inflation in future years. For example, if a taxpayer has purchased a brand new (never been previously used) MRI in 2016, you can immediately deduct 50 percent of its cost in 2016 (bonus depreciation) and depreciate the remainder over its tax life. Thus, for assets with five-year tax lives, taxpayers can generally deduct 60 percent of the equipment cost in 2016 (50 percent of bonus depreciation plus 10 percent of normal depreciation).
For those who believe they are eligible for the R&D credit or the equipment purchasing deductions, the calculations are complex, so I recommend you consult your tax professional who is knowledgeable on these changing laws and regulations and the tax planning opportunities they present.
Arthur Van Buren is a shareholder within the LBMC Tax Practice and leads the firm's healthcare tax practice. He can be reached at firstname.lastname@example.org.