Developing Software, Receiving Substantial Royalties from Controlled Corporation, Insufficient Trade or Business for Section 174 Deductions
R&D Tax Alert - October 2007
Background
Section 174 requires thatits deductions be incurred in connection with a taxpayer’s trade or business. Not just any trade or business, but thetaxpayer’s own. Because of the specialcharacter of R&D deductions, the Supreme Court has ruled that not onlyongoing, but also prospective trades or businesses can qualify a taxpayer forthe deduction.
A taxpayer can get thededuction for R&D expenses if the taxpayer has a “reasonable prospect” thatit will subsequently enter into a trade or business utilizing the technologydeveloped. “Reasonable prospect” has twoelements in the jurisprudence of R&D: a capability to enter a business and an objective intent to do so. The 9th Circuit Court of Appeals recentlyaffirmed a Tax Court decision holding that a software developer failed tomanifest an “objective intent” in developing software to be licensed by him toa controlled corporation for substantial royalties.
Guidance
The 9th Circuit opinion isDavid M. Saykally v. Commissioner, 100 AFTR2d 2007-5250 (9th Cir. 8/16/2007), affirming T.C. Memo 2003-152. While the 9th Circuit’s opinion is unpublished and therefore may not becited as precedent in that Circuit, the Tax Court opinion it affirms provides acautionary tale about too-sophisticated business structures causing disastroustax results. In short, Mr. Saykally contractedwith his wholly-owned C Corporation to develop software for use by thatcorporation. He incurred millions inexpenses in doing so and received substantial royalties from the C Corporationfor the results of his efforts, but those royalties were not paid during theyears at issue. The Tax Court held that,because the taxpayer was developing software for use in the C corporation’sbusiness and had no intent of using the software himself, he failed to manifestthe “objective intent” that is the second part of the “reasonable prospect” test. Nowhere in the Tax Court opinion is itsuggested that leasing software for royalties was in itself a trade orbusiness.
Summary
The reason this result – nodeductions to the taxpayer – is disastrous is that the controlled C Corporationdisclaimed any intent to use the section 174 deduction. Thus, neither the taxpayer nor his controlledcorporation received the benefits of section 174. The lesson to be taken from Saykally is thatany taxpayer developing software exclusively for lease/sale should also stateintent to use that software in its own business. It was, apparently, Saykally’s statement thathe could not use the software in his personal business that doomed hiscase. RIA has suggested that the resultin Saykally might have been different had the C corporation been a single-ownerLLC, in which case the Tax Court might have been more likely to ascribe itsbusiness activities to Mr. Saykally.
For more information
If you have questions thatyou would like to discuss further, please contact Jerry Parshall, National Tax,at 301.296.3624 or gerald.parshall@rsmi.com.
