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The Internal Revenue Service is more aggressively challenging claims bysoftware companies for research credits for software development. Armed withtwo favorable court decisions on credit claims for “internal-use” software(developed primarily for internal use rather than sale), the IRS has adopteda parsimonious stance for all research credit claims – not just claims basedon internal-use software research. On Dec. 2, 1998, the IRS issuedcontroversial proposed regulations that echo the language in thesedecisions.

Although the IRS’s increased scrutiny of research credit claims is notlimited to software developers, the software industry should pay particularattention to research credit audit trends and court decisions. First, bystatute, internal-use software development is subject to tougherrequirements than other types of research. Second, in addition to thegeneral eligibility standards and the special requirements for internal-usesoftware, a third test for product software (developed for sale tocustomers) may be emerging in the IRS and the courts. However, thelegislative history of the research credit demonstrates that Congressintended product software to be treated the same as nonsoftware researchactivities. Product software developers should resist IRS attempts torestrict availability of the credit for otherwise qualified research.

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