Uncle Sam Giveth, Uncle Sam Taketh Away

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Back in 1981, Congress did a nice thing for the cause of technological innovation -- or so it seemed at the time. Included in that year's Economic Recovery Tax Act (ERTA) was a special tax credit for research and development. Under the new law, a company that increased its R&D expenditures could deduct 25% of the increase from its total federal tax bill for that year.

This credit provided a great incentive for companies to invest in R&D. It was much better than a tax deduction, which allows you to reduce only your taxable income for the year. In contrast, a credit is subtracted from the actual amount owed to the Internal Revenue Service. It thus constitutes a kind of "tax reward."

Among those that apparently stood to gain from this credit were companies that developed their own software. Granted, ERTA didn't actually say that the tax credit covered in-house software development. But the IRS has traditionally treated such expenditures as a form of R&D.

At any rate, most tax professionals believed that the new credit applied to software development. "Virtually all businesses may benefit from these new rules because research activities are broadly defined and include computer software development," proclaimed the prestigious accounting firm of Arthur Andersen & Co. in the February 8, 1982, issue of its Client Information Letter. "Taxpayers can reap immediate benefits from this new credit, as it applies to qualified expenditures paid or incurred after June 30, 1981, and before 1986. . . . The R&D credit applies to software development in a broad sense. . . . That is, software development in and of itself constitutes qualified research."

Well, not so fast.

On January 21, 1983, the IRS finally got around to publishing its own interpretation of the R&D tax credit provided by ERTA. And, lo and behold, most software development costs will not be eligible.

Specifically, the IRS proposed a new tax regulation, under which software development would not be considered R&D unless the software is "new or significantly improved." At the same time, the IRS established a "litmus test" for eligibility, namely: There "must exist a significant doubt that you can achieve whatever result you want to achieve from the software." In other words, the money you spend on software development will only qualify for the tax credit if you are running a substantial risk of failure.

By all accounts, this new regulation -- if it stands -- would represent a major change in the definition of R&D for tax purposes. The immediate upshot would be that most software development costs wouldn't qualify for the R&D tax credit. Moreover, many accountants and tax attorneys believe that the regulations could force companies to capitalize or amortize certain software development expenses, a point conceded by the IRS. In the past, companies have been allowed to deduct those expenses each year, as "ordinary and necessary" costs of doing business. But, given the new, revised definition of R&D, they may now have to spread out the deductions over several years, thereby postponing -- and perhaps losing -- some of the tax benefits.

The software industry responded to the ruling with a call to arms. The American Electronics Association issued an "Action Alert" to its 2,000 member companies urging them to "help persuade the IRS to modify its initial proposal."

Tax specialists, meanwhile, expressed their horror. "The proposed regulations represent a bombshell for companies that create computer programs either for their own use or to market to others," said Roy N. Freed and Walter G. Van Dorn, partners in the Boston law firm of Powers & Hall, in a prepared statement. "The IRS appears to have gone far beyond its charter in drafting the regulations." Referring to the new "significant doubt" standard for eligibility, Freed and Van Dorn noted that software development "is essentially engineering work in the nature of systems analysis and systems design, and the success of the. . . work performed by competent people rarely should be seriously in doubt. . . . If the regulation becomes law, the cost of creating programs will be increased substantially by the need to pay higher taxes. That would be counterproductive in stimulating economic recovery constructively."

Said Charles J. Medallis, a partner in the Boston office of Arthur Andersen & Co.: "The entire business community is very shocked by how narrow the IRS came out with respect to computer software." There is a serious doubt, he said, that the "regulations reflect congressional intent."

The IRS, for its part, was accepting any and all public comments until March 25. A public hearing was set for April 19 in Washington, D.C., with a final decision to be handed down sometime following that hearing. If the new rules are adopted, companies that claim the R&D tax credit for software development will have to decide whether to file amended returns, or fight it out in an audit. Until then, however, the old rules remain in effect.