Definitions — Instruction 6765 — Instructions for Form

Qualified Research The research credit is generally allowed as a percentage of qualified research expenses over the base amount. “Qualified research expenses” are the sum of in-house research expenses and contract research expenses paid or incurred by the taxpayer in carrying on any trade or business of the taxpayer. Qualified research generally means research (1) with respect to which expenditures are treated as domestic research or experimental expenditures under section 174A, (2) which is undertaken for the purpose of discovering information that is technological in nature, (3) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and (4) substantially all of the activities of which constitute elements of a process of experimentation relates to a new or improved function, performance, or reliability or quality. These requirements are commonly referred to as the “four-part test.” The four-part test must be applied separately with respect to each business component of the taxpayer.

In addition, substantially all of the activities of the research must be elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality. The four-part test must be applied separately with respect to each business component of the taxpayer.

Excluded activities. The research credit isn’t allowed for the following types of activities.

Research conducted after the beginning of commercial production.
Research adapting an existing product or process to a particular customer’s need.
Duplication of an existing product or process.
Surveys or studies.
Research relating to certain internal-use computer software.
Research conducted outside the United States or a U.S. territory, such as Puerto Rico.
Research in the social sciences, arts, or humanities.
Research funded by another person (or governmental entity).

If you incur qualified clinical testing expenses relating to drugs for certain rare diseases, you can elect to claim the orphan drug credit for these expenses instead of the research credit. See Form 8820, Orphan Drug Credit.

See section 41 and Regulations sections 1.41-2 and 1.41-4 for other definitions and special rules.

Business Component A business component is any product, process, computer software, technique, formula, or invention which is to be held for sale, lease, or license, or used by the taxpayer in a trade or business of the taxpayer. Any plant process, machinery, or technique for commercial production of a business component is treated as a separate business component (and not as part of the business component being produced). For purposes of simplified reporting on this form, the options for business component type, for column 49(d), are “Product,” “Process,” or “All Others.”

Research With Respect to Software Research with respect to software that is developed by, or for the benefit of, the taxpayer primarily for the taxpayer’s internal

use, referred to as internal use software, is eligible for the research credit only if:

Research with respect to software is qualified research. See Qualified Research , earlier;
Research with respect to software is not otherwise excluded, see Excluded activities, earlier; and
The software satisfies the high-threshold-of-innovation (HTI) test. Software satisfies the HTI test, if the taxpayer can establish that:

a. The software is innovative; b. The software development involves significant economic risk, where the taxpayer commits substantial resources to the development and there is substantial uncertainty, because of technical risk, that those resources would be recovered within a reasonable period; and

c. The software is not commercially available for use by the taxpayer in that the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications meeting both a and b requirements.

See Regulations section 1.41-4(c)(6)(vii).

Internal use software (IUS). IUS is software developed by, or for the benefit of, the taxpayer primarily for the taxpayer’s internal use if the software is developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business. General and administrative functions are financial management, human resources management, and support services functions. See Regulations section 1.41-4(c)(6)(iii)(B) for examples of general and administrative functions and Regulations section 1.41-4(c)(6)(viii) for illustrations.

Dual function software (DFS). DFS is software developed by, or for the benefit of, the taxpayer both for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business and to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system. DFS is presumed to be developed primarily for a taxpayer’s internal use and is subject to the same requirements as IUS.

The regulations provide a way for the taxpayer to overcome the presumption that the DFS is for the taxpayer’s internal use to the extent that a taxpayer can identify a third-party subset, which is the subset of elements of DFS that only enables a taxpayer to interact with third parties or allows third parties to initiate functions or review data on the taxpayer’s system. Such third-party subset is not IUS and not subject to the HTI test. However, the remaining software (dual function subset) is still treated as IUS and must satisfy the HTI test. See Regulations section 1.41-4(c)(6)(vi).

As a safe harbor, a taxpayer may, after attempting to identify the third-party subset, include 25% of the remaining QREs of DFS or a subset of DFS elements (also known as dual function subset) in computing the amount of the taxpayer’s credit. Additional conditions must be met. See Regulations section 1.41-4(c)(6)(vi)(C).

Excepted from IUS treatment. See Regulations section 1.41-4(c)(6)(ii) for three exceptions to the applicability of the HTI test for IUS.

Non-IUS. Software is not developed primarily for the taxpayer’s internal use if it is not developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s business, such as:

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Software developed to be commercially sold, leased, licensed, or otherwise marketed to third parties; or
Software developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system.

When completing Section G, line 49(e), if the business component is software, select only from the following categories.

A. IUS—internal use software B. DFS—dual function software

Where no third-party subset is identified, DFS safe harbor isn’t applied.
Where third-party subset(s) is identified (remaining dual function subset subject to HTI test).
With the safe harbor applied (25% of expenses that meet all conditions). C. Excepted from IUS treatment
Where taxpayer developed software for use in an activity that constitutes qualified research.
Where taxpayer developed software for internal use in a production process to which the requirements of section 41(d)(1) are met.
Where a new or improved package of software and hardware developed together by the taxpayer as a single product (or to the costs to modify an acquired software and hardware package), of which the software is an integral part, that is used directly by the taxpayer in providing services in its trade or business. In these cases, eligibility for the research credit is to be determined by examining the combined hardware-software product as a single product. D. Non-IUS
Developed to be commercially sold, leased, licensed, or otherwise marketed to third parties.
Developed to be used internally by the taxpayer but not in any general and administrative function(s) of the taxpayer.
Developed to interact with third parties but not to be used in any general and administrative function.

“80%/Top 50” business components. If you are required to complete Section G, you must report by business component, a minimum of 80% of total QREs or a maximum of 50 business components. In these instructions, this is referred to as the “80%/Top 50” business components. Business components should be listed in descending order by QRE amount.

Aggregate Business Components. Any business components remaining after identifying the 80%/Top 50 business components will be reported in aggregate by entering “Aggregate Business Components” in column 49(c) and the applicable aggregate amounts for columns 50 through 56; leave all other columns in Section G blank. This will be referred to as the “Aggregate Business Components” in these instructions.

Eligible Small Business (For Purposes of Offsetting AMT Only) An eligible small business is:

A corporation whose stock isn’t publicly traded,
A partnership, or
A sole proprietorship.

The average annual gross receipts of the corporation, partnership, or sole proprietorship for the 3-tax-year period preceding the tax year of the credit can’t exceed $50 million. Gross receipts for any tax year must be reduced by returns and allowances made during the year. Any reference to your business also includes a reference to any predecessor of your business. If your business wasn’t in existence for the entire 3-year period, base your average annual gross receipts on the period your business existed. Also, if your business had a tax year of less than 12 months, your gross receipts must be annualized by multiplying the gross receipts for the short period by 12 and dividing the result by the number of months in the short period.

Note: Gross receipts must meet the definition under section 448(c)(2) and (3) and Regulations section 1.448-1T(f)(2)(iv). Member of controlled group, trade or business under common control, or affiliated group. For purposes of the gross receipts test, all members of a controlled group of corporations (as defined in section 52(a)) and all members of a group of trades or businesses under common control (as defined in section 52(b)) are treated as a single employer; and all employees of the members of an affiliated service group (as defined in sections 414(m) and (o)) shall be treated as employed by a single employer.

Treatment of partners and S corporation shareholders. A partner or S corporation shareholder can’t be treated as an eligible small business unless both the partnership or S corporation and the partner or S corporation shareholder meet the gross receipts test, as discussed under Eligible Small Business (For Purposes of Offsetting AMT Only) , earlier, for the tax year that the credit is treated as a current year general business credit.

Qualified Small Business (Payroll Tax Credit Election) A qualified small business is a corporation (including an S corporation) or partnership with:

Gross receipts of less than $5 million for the tax year, and
No gross receipts for any tax year before the 5-tax-year period ending with the tax year.

Any other person may be considered a qualified small business if the person meets the requirements of (1) and (2), taking into account the aggregate gross receipts received in all the trades or businesses.

The term “gross receipts” for purposes of determining whether your business is a qualified small business means gross receipts, as determined under section 448(c)(3) (without regard to subparagraph (A) thereof) and Regulations sections 1.448-1T(f)(2)(iii) and (iv). The definition of gross receipts under section 41(c)(6) and Regulations section 1.41-3(c) doesn’t apply for this purpose. Any reference to your trade or business also includes a reference to any predecessor of your trade or business. Also, if your trade or business had a tax year of less than 12 months, your gross receipts must be annualized by multiplying the gross receipts for the short period by 12 and dividing the result by the number of months in the short period.

A qualified small business doesn’t include a tax-exempt organization under section 501.

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Payroll Tax Credit Election The payroll tax credit election is an annual election made by a qualified small business specifying the amount of research credit, not to exceed $500,000, that may be used against the employer portion of social security liability. The credit is the smallest of the current year research credit, an elected amount not to exceed $500,000, or the general business credit carryforward for the tax year (before the application of the payroll tax credit election for the tax year). The general business credit carryforward limitation doesn’t apply to partnerships or S corporations. The election must be made on or before the due date of the originally filed income tax return (including extensions). An election can’t be made for a tax year if an election was made for 5 or more preceding tax years. The election made by a partnership or S corporation is made at the entity level. Any election to take the payroll tax credit may be revoked only with the consent of the IRS. For more information about the payroll tax credit, see Notice 2017-23, 2017-16 I.R.B. 1100, available at IRS.gov/irb/ 2017-16_IRB#NOT-2017-23 . Claiming the credit on an employment tax return. A qualified small business that elects to claim the payroll tax credit will claim the payroll tax credit against the employer’s portion of social security tax on its employment tax return for the first quarter that begins after it files the return reflecting the payroll tax election. See Notice 2017-23 for more information. A qualified small business claiming the payroll tax credit on its employment tax return must complete Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, and attach the completed form to the employment tax return.