Best Practices: Texas vs Software

Q: We are not a software company but are heavily investing in our IT department. They are developing automated functions to assist our business operations, reduce human error and help maintain regulatory compliance. Our developers are located in Texas, do our software development activities qualify for the Texas R&D credit?

Colette Gagnet answers:

Texas has a complicated relationship with software development, especially when the software is not held for sale, lease, or license. The federal regulations provide several exceptions for internally developed software or internal use software (“IUS”) to be qualified activity under Sec. 41. Historically, Texas has taken a different approach. First, the state has only adopted the Internal Revenue code as of 2011. This decoupling throws us back to either the Discovery Test or the Computer vs Non-computer services analysis. The discover test limits the definition of qualified research to only information that “exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering.”

This test is often difficult to document within the software space. The analysis of computing versus non-computing services could trigger certain development activity to be classified as software as a service (“SAAS”) which is subject to sales tax in Texas. The icing on the cake came with the issuance of the October 2021 final amendments where the Texas Comptroller redefined qualified activity to specifically exclude “internally developed computer software.” While the Texas credit may be off the table, there are still some benefits at the federal level. It’s a complicated analysis but you’ll need to consider these new (and old) rules when evaluating the qualified activity at the state level.