10th Circuit Disallows R&D Tax Credit for Software Development Costs

August 30, 2002. The U.S. Court of Appeals (10thCir) issued its opinion in Tax and Accounting Software Corp. v. IRS, a case regarding when expenses of a software company may qualify for the research and development tax credit. The Appeals Court reversed a District Court summary judgment in favor of a small software development company, on the grounds that its expenses were not for "qualified research".

Background. Tim and Sheryl Kloehr are the sole owners of a Subchapter S corporation, Tax and Accounting Software Corporation (TAASC), that develops and markets software for use by tax and accounting professionals. In 1993 and 1994 TAASC incurred a total of $1,838,756 and $2,444,938 in research and development expenses for the development of these software products. TAASC claimed a portion of these expenses as research and development tax credits under 26 U.S.C. § 41. The Internal Revenue Service (IRS) disallowed these tax credits. The Kloehrs paid the deficiencies.

District Court. TAASC and the Kloehrs filed a complaint in U.S. District Court (NDOkla) against the USA seeking a refund. The District Court granted summary judgment to TAASC and the Kloehrs. It held that Section 41(d)(1) does not require the taxpayer to expand or refine principles of science or engineering in order to qualify for the tax credit. It wrote that the "emphasis should be on whether the information qualifies as being 'technological in nature' ... , not whether the work could be considered a revolutionary discovery in the scientific sense." See, 111 F. Supp. 2d 1153, at 1158. The IRS appealed.

Statute. Section 41(d)(1) provides as follows:
Qualified research defined
For purposes of this section --
(1) In general
The term ''qualified research'' means research --
(A) with respect to which expenditures may be treated as expenses under section 174,
(B) which is undertaken for the purpose of discovering information (i) which is technological in nature, and (ii) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and
(C) substantially all of the activities of which constitute elements of a process of experimentation for a purpose described in paragraph (3).

Appeals Court. The Appeals Court reversed. The dispute was over application of the "qualified research" requirement.

The IRS conceded that the Kloehrs' expenses were expenses within the meaning of 41(d)(1)(A), that the expenses were "intended to be useful in the development of a new or improved business component of the taxpayer" within the meaning of 41(d)(1)(B)(ii), and that expenses were for research that was "technological in nature" within the meaning of 41(d)(1)(B)(i).

However, the IRS disputed that the expenses were "undertaken for the purpose of discovering information" within the meaning of 41(d)(1)(B), and that the expenses met the requirement of 41(d)(1)(C) ("substantially all of the activities of which constitute elements of a process of experimentation"). The IRS argued that the research must expand or refine the principles of computer science to qualify.

The Appeals Court wrote that "the statute requires that the taxpayer's research, in order to qualify, must have developed new information that is applied towards the development of a product. This is the "discovery" requirement of § 41. Contrary to TAASC's arguments, mere evidence that the taxpayer has developed a new and useful product in and of itself will not qualify. Contrary to the government's argument, the new information need not ``expand, or refine, principles of the physical or biological sciences, engineering, or computer science.´´ In other words, each of the positions of the parties is incorrect." (Footnote and citation omitted.)

The Appeals Court concluded that "the ``discovering information´´ language of § 41 establishes a separate requirement that the taxpayer must meet in order to qualify for the tax credit. Under that requirement, the taxpayer must show that he discovered new information and that information must be separate from the product that is actually developed." The Court added that "This issue was never developed by either party below, and thus summary judgment for TAASC was inappropriate on this issue."

The Appeals Court reversed and remanded.

Congress. The R&D Tax Credit is a perennial issue in Congress. The credit was first enacted in 1981 as a temporary measure, and has been extended temporarily on many occasions since then. Under the current scheme, corporations receive a 20% tax credit for qualified research and development expenditures (QREs) in excess of a calculated base amount. The Congress passed, and President Clinton signed, a bill which extends the R&D tax credit for another five years at the end of 1999. However, efforts to make the credit permanent continue.