Federal tax in AI mergers and acquisitions

In short

The federal tax outcome of an AI company acquisition starts with a single structural choice. The deal can be a taxable purchase, in which the seller recognizes the gain and the buyer gets a stepped up basis in assets, or a tax free reorganization under Internal Revenue Code section 368, in which the seller defers the gain and the tax attributes carry over. 26 CFR §1.368-1, 26 U.S.C. §354, 26 U.S.C. §361, 26 U.S.C. §381, 26 U.S.C. §1001, 26 U.S.C. §1012 The One Big Beautiful Bill Act of 2025, signed July 4, 2025, changed the stakes. It made permanent 100 percent bonus depreciation. Bernstein, Law firm analysis, RSM Each change moves the numbers in a deal priced on after tax cash flows and on the value of the target’s net operating losses and future deductions.

How do you choose between a taxable and a tax free structure?

The first decision in an AI acquisition is whether the buyer and seller want a taxable or a tax free transaction. The choice determines when the seller pays tax, what the buyer’s basis is in the acquired assets, and whether the target’s tax attributes, like its net operating losses, its R&D credit carryforwards, and its accounting methods, survive the closing.

A taxable deal

In a taxable acquisition, the seller recognizes gain or loss on the sale. The buyer records the acquired assets at their fair market value, which usually means a step up in tax basis. This step up allows the buyer to deduct more depreciation and amortization in future years. But a taxable deal also triggers an immediate tax bill for the seller, and if the target is a C corporation selling its assets, the gain is taxed twice, once at the corporate level and again when the proceeds are distributed to shareholders.

Buyers in AI deals often want an asset purchase rather than a stock purchase because an asset purchase gives them a fresh tax basis in the target’s intangible property such as the trained models, the datasets, the customer lists, the trademarked names. A stock purchase, by contrast, leaves the target’s own tax basis in place. The seller gets one level of tax on the stock sale, but the buyer does not get to step up the basis of the assets inside the target.

Consider Databricks’ 2023 acquisition of MosaicML, valued at about $1.3 billion. It was structured as a stock deal, with Databricks paying in its own stock rather than cash. Fortune Because it was a stock purchase and not an asset purchase, Databricks did not step up the basis of MosaicML’s intangibles, and the deal produced no new amortization deductions under section 197.

A tax free reorganization

A tax free reorganization under section 368 lets the seller’s shareholders swap their stock for stock of the acquirer without recognizing gain immediately. The trade-off is that the acquirer takes over the target’s tax basis (a carryover basis) instead of a step up. The target’s tax attributes, like NOLs and R&D credits, carry over and stay subject to limits like section 382.

There are several flavors of tax free reorganization. The most common ones used in AI M&A are described below. Generally, a reorganization must satisfy a business purpose test, the continuity of business enterprise test (the buyer runs the target’s historic business or uses a significant portion of its assets in a business), and the step transaction doctrine. Treas. Reg. §1.368-1

• Type A reorganization. A statutory merger or consolidation. The target disappears into the acquirer. At least 40 percent of the consideration must be stock of the acquirer to meet the continuity of interest test, and the rest can be cash, property, or other securities. Treas. Reg. §1.368-1(e)
• Type B reorganization. A stock for stock acquisition. The acquirer uses only its own voting stock to buy enough target stock to get control, meaning at least 80 percent of the voting power and at least 80 percent of each nonvoting class. No boot is permitted except for a small amount of cash used to round off fractional shares. 26 U.S.C. §368(a)(1)(B), Rev. Rul. 66-365
• Type C reorganization. A stock for assets acquisition. The acquirer uses its voting stock to acquire substantially all of the target’s assets, defined as at least 70 percent of the fair market value of gross assets and at least 90 percent of the fair market value of net assets. The acquiring corporation must acquire, solely for voting stock, property worth at least 80 percent of the fair market value of all the target corporation’s property, and assumed liabilities are treated as money for this test. 26 U.S.C. §368(a)(2)(B)
• Type F reorganization. A mere change in identity, form, or place of organization. This is often used as a pre closing step, not as the main acquisition structure. It allows an S corporation target to drop its assets into a new corporation, make a QSub election, and become a disregarded entity for federal tax purposes while keeping its employer identification number. Once that is done, the buyer can treat a later stock sale as an asset sale under the deemed asset election rules explained next. Rev. Rul. 2008-18.

Deemed asset elections, getting a step up in a stock sale

Sometimes the deal needs to be a stock purchase for regulatory, contractual, or commercial reasons, but the buyer still wants an asset step up. Two elections can treat a qualifying stock purchase as if the target sold its assets and then liquidated.

A section 338(h)(10) election requires a single corporate buyer to buy at least 80 percent of the target’s stock within a 12 month period. The election must be made jointly by the buyer and the seller. The target is deemed to sell all its assets for fair market value and then liquidate. The buyer gets a stepped-up basis in the assets. The target’s shareholders recognize one level of tax. This election is not available when the buyer is a partnership or an individual. 26 U.S.C. §338

A section 336(e) election is broader. It can be used when the buyer is not a corporation, or when multiple buyers acquire the target’s stock. The seller and target make a joint election to treat the stock disposition as a deemed asset sale. 26 U.S.C. §336(e), 26 CFR §1.336-2

For an S corporation target, a common sequence is to first complete an F reorganization. The target contributes its assets to a new corporation, makes a QSub election, and becomes a disregarded entity. The next day, a corporate buyer purchases the stock of the disregarded entity and, together with the seller, makes a section 338(h)(10) election. The result is an asset step up for the buyer and one level of tax for the S corporation shareholders. Rev. Rul. 2008-18.

A real example of a tax free deal in AI

In July 2025, CoreWeave agreed to acquire Core Scientific in an all stock transaction valued at about $9 billion, structured as a tax free reorganization under section 368(a). Merger Agreement (EX-2.1) The all stock structure would have let the target’s tax attributes carry over, eliminated about $10 billion in forward lease obligations, and added roughly 1.3 gigawatts of power capacity. Core Scientific shareholders rejected the deal, and the parties terminated the merger on October 30, 2025, a reminder that even a well structured reorganization can fail at the shareholder vote.

What happens to the target’s R&D costs in an AI acquisition?

AI companies spend heavily on research and development, including model training, algorithm tweaking, and data pipeline engineering. How those costs are treated for tax purposes drives a big part of the pre deal due diligence and the post deal integration.

The pre OBBBA capitalization rule and the phantom income problem

For tax years 2022, 2023, and 2024, the Tax Cuts and Jobs Act required firms to capitalize and amortize most of their software development costs. That included AI model training and fine tuning. Domestic costs were written off over five years, foreign costs over fifteen years. IRS Notice 2023-63, RSM

The result was painful for AI startups. They might spend $10 million on R&D in a year but only deduct $2 million of it. That created phantom taxable income, reported profit far above their actual cash flow. SaaS Capital The unamortized balance sat on the balance sheet as a deferred tax asset, but realizing it depended on future deductions that were years away.

The OBBBA fix, section 174A

The One Big Beautiful Bill Act, signed July 4, 2025, added new section 174A. For tax years beginning after 2024, domestic research and experimental expenditures are immediately deductible again. Foreign expenditures remain amortized over 15 years. EisnerAmper

The law also gave two retroactive relief options. Small taxpayers, those with average annual gross receipts of $31 million or less over the last three years, can go back and fully deduct the domestic R&D costs they had to capitalize during 2022 through 2024. They do this by filing amended returns or a Form 3115 change in accounting method. All taxpayers can deduct the leftover capitalized amounts entirely in 2025, or spread them equally over 2025 and 2026. EisnerAmper

Why this matters in an acquisition

For the buyer. In a stock acquisition, the buyer inherits the target’s section 174 accounting method and any historical tax exposure from underpaid taxes due to capitalization. In an asset acquisition, the buyer starts fresh with its own methods. The buyer must also evaluate whether the target’s deferred tax asset from capitalized R&D is realizable post closing. If the target is acquired by a company with enough future taxable income, that DTA becomes valuable. Otherwise, a valuation allowance reduces its carrying value. Tax analysis

For the seller. The capitalized R&D costs create tax basis in the related intellectual property. If the seller disposes of that IP in a taxable asset sale, section 174(d) forces the seller to keep amortizing the unamortized foreign R&D balance on the old schedule, with no deduction or reduction to amount realized allowed for those expenditures. 26 U.S.C. §174(d)

Impacting QSBS status. The capitalized R&D assets count toward the $50 million aggregate gross asset threshold in section 1202 for qualified small business stock. If a company’s gross assets exceeded that limit because of those capitalized costs, its stock lost QSBS eligibility. The OBBBA retroactive election to expense those costs can reverse that and restore QSBS status. Tax alert, EisnerAmper

A trap for AI founders. A startup that raised money believing its stock was QSBS may discover during sale due diligence that it lost the exclusion because of prior-year capitalized R&D. Making the OBBBA retroactive election is time sensitive and must be analyzed early.

How are acquired AI intangibles amortized for tax purposes?

When an AI company is acquired in a taxable asset deal, or a stock purchase with a deemed asset election, the buyer allocates the purchase price among the target’s tangible and intangible assets. The allocation follows the residual method under section 1060, reported on Form 8594. The service requires the buyer and seller to file matching forms. IRS Form 8594 Instructions

The residual method assigns assets to one of seven classes. They are listed in the order the form requires.

• Class I. Cash and cash equivalents.
• Class II. Actively traded personal property, like marketable securities.
• Class III. Accounts receivable.
• Class IV. Inventory.
• Class V. Tangible assets, such as servers, equipment, and real property.
• Class VI. Section 197 intangibles other than goodwill and going concern value.
• Class VII. Goodwill and going concern value.

Almost every intangible that gives an AI company its value falls into Class VI or VII. Section 197 says those intangibles must be amortized ratably over 15 years (180 months), using the straight line method. 26 U.S.C. §197(a) The statute specifically lists goodwill, going concern value, workforce in place, information base, patents, copyrights, formulas, processes, designs, patterns, know-how, and formats, customer-based intangibles, supplier-based intangibles, and government licenses, covenants not to compete, franchises, trademarks, and trade names. 26 U.S.C. §197(d)(1)

For an AI target, those terms cover many of the most valuable assets.

• Trained model weights and proprietary algorithms. Generally treated as know-how or goodwill.
• Custom data pipelines and unique datasets. Information base or know-how.
• Customer lists and recurring enterprise contracts. Customer-based intangibles.
• Non compete agreements with founders. Covenants not to compete.

Some assets may be excluded from section 197 under subsection (e)(4). That covers separately acquired software, patents, or copyrights that are not part of a trade or business acquisition. Those assets fall under the regular depreciation rules of section 167 and might have shorter recovery periods. 26 U.S.C. §197(e)(3), 26 U.S.C. §197(e)(4), 26 U.S.C. §167(f), 26 U.S.C. §168(k) For example, a buyer who acquires a standalone AI software library and not the entire business could depreciate it over 3 or 5 years or take an immediate expense under bonus depreciation.

The pooling rule in section 197(f)(1) is a real trap. All section 197 intangibles from a single transaction are lumped into one amortization pool. If the buyer later sells or abandons one of those intangibles, it cannot deduct the remaining unamortized basis of that asset. Instead, the basis stays in the pool and continues to amortize. A loss is recognized only if the buyer disposes of every single section 197 intangible from that acquisition. [Beancount.io](https://beancount.io/blog/2026/05/11/section-197-amortization-intangibles-asset-acquisition-goodwill-customer-lists-non competes-15-year-write-off-guide)

The anti churning rule of section 197(f)(9) can deny amortization altogether if the target or a related party held the intangible during a specified lookback period and the user does not change after the deal. The related party threshold is more than 20 percent common ownership, which is lower than the usual 50 percent test. This rule can become a problem in F reorganization sequences where self-created AI models of a target are converted into deemed purchased assets. The IRS’s position in this scenario is not fully settled, and practitioners should expect scrutiny.

Purchase price allocation example

Suppose a buyer pays $100 million for the assets of an AI startup. The tangible assets, mostly servers and equipment, are worth $5 million. The remaining $95 million must be allocated among Class VI and VII intangibles. If there is a customer list, a non-compete agreement, and trained models, the parties must agree on values and report them on Form 8594. The buyer will then amortize $95 million over 15 years, deducting $6.33 million each year, no matter how long the assets actually generate income.

Can the buyer use the target’s net operating losses?

Many AI startups have large net operating losses. In a tax free reorganization, those NOLs carry over to the acquirer, but their use is limited by section 382. In a taxable stock purchase, the NOLs remain with the target (now a subsidiary) and are similarly limited. In an asset purchase, NOLs generally do not transfer to the buyer.

Section 382 imposes an annual limit on NOL usage when a loss corporation undergoes an ownership change. An ownership change happens when one or more five percent shareholders increase their ownership by more than 50 percentage points over their lowest ownership during a rolling three year testing period. 26 U.S.C. §382, Plante Moran

The annual NOL limit is calculated by multiplying the fair market value of the loss corporation’s stock immediately before the ownership change by the federal long term tax exempt rate. For a company worth $100 million and a rate of 3 percent, the annual limit would be $3 million. Phoenix Strategy Group

AI startups that raised several preferred stock rounds often trigger ownership changes without knowing it. The test looks at value, not share numbers. A new Series B investor buying 20 percent of the shares may represent 50 percent of the value if the per share price is much higher than common stock. That shift can cross the 50 percentage point threshold. 26 U.S.C. § 382(g)

Once the limit is in place, only a fixed dollar amount of NOL can be used each year. If the company also has built in gains, meaning unrealized appreciation in its assets, those gains recognized within five years after the ownership change increase the limit. Built in losses are treated as pre change losses subject to the limit, reducing the amount of other pre-change losses that may be used. Valuation Research Corp

For the buyer in an AI acquisition, this means that the target’s NOLs, which might appear large, could be virtually worthless after closing. Buyers must commission a section 382 ownership change study as part of due diligence.

The pre deal surprise. A target that thought it had $50 million of usable NOLs may learn only $500,000 per year can be used. The buyer’s valuation model must account for that.

Also, if a tax free reorganization fails the continuity of business enterprise test, for instance, the buyer shuts down the target’s business and only uses the models, the section 382 limitation for post change years can be set at zero. Phoenix Strategy Group

How is equity compensation taxed in an AI acquisition?

When an AI company is bought, the treatment of outstanding stock options, restricted stock units, and founder equity can generate immediate tax headaches for both the company and the employees.

Vesting acceleration and section 83

Deal agreements often accelerate the vesting of unvested equity so that employees get their shares just before or after the closing. When the vesting restriction lapses, the employees recognize ordinary income equal to the fair market value of the shares at that moment, and the company gets a corresponding deduction. 26 U.S.C. §83 For founders who filed a section 83(b) election within 30 days of stock grant, the value at grant was already taxed, so the acceleration does not create additional income. Instead, the sale at closing produces capital gain.

Incentive stock options in an acquisition

Incentive stock options receive favorable tax treatment. No ordinary income is triggered at exercise if the shares are held for the required periods. In a stock for stock tax free reorganization, if the acquirer assumes the ISOs and substitutes its own stock under section 424(a), the ISOs can keep their tax favored status. But if the acquisition is for cash, or if the options are cashed out without a qualifying substitution, the ISO treatment is lost and the employee faces ordinary income plus FICA taxes on the bargain element. LinkedIn/Ryan Wang

Section 409A and deferred compensation

Restricted stock units and other deferred compensation arrangements must comply with section 409A’s strict timing rules. The most important safety valve is the short term deferral exception. If the compensation is paid within two and a half months after the taxable year in which the vesting occurs, section 409A does not apply. Treas. Reg. §1.409A-1(b)(4) If the deal causes a delay that pushes settlement past that window, or if the compensation was not designed properly, the result can be immediate taxation, a 20 percent additional tax, and penalty interest. PwC

The golden parachute trap under section 280G

Section 280G imposes a punitive regime on excess parachute payments made to disqualified individuals when a change in control occurs. Those individuals include officers, shareholders above one percent, and the most highly compensated one percent of employees. A parachute payment is any payment contingent on the change in control that equals or exceeds three times the individual’s base amount. The base amount is the average annual compensation over the last five years. The excess over one times the base amount is nondeductible by the corporation, and the individual pays a 20 percent excise tax under section 4999 on top of ordinary income taxes. 26 U.S.C. §280G, 26 U.S.C. § 4999

Accelerated vesting of equity counts toward the parachute calculation. Imagine a founder who earned a $300,000 salary but holds $1.2 million of unvested stock that vests at closing. The base amount is $300,000, and three times that is $900,000. The $1.2 million exceeds $900,000, so $900,000 is treated as an excess parachute payment. That $900,000 is nondeductible to the company and the founder pays an extra $180,000 in excise tax on top of the income tax on the full $1.2 million. The effective combined tax rate can top 67 percent. LinkedIn/Ryan Wang

Private companies can mitigate this trap by holding a shareholder vote to approve the parachute payments before the closing, but the vote must meet specific requirements and be planned well in advance.

How do international tax rules affect an AI deal?

Many AI companies generate income from customers overseas, or develop technology through subsidiaries in lower tax jurisdictions. The tax treatment of that foreign income can shift the net after tax return to the buyer.

GILTI becomes NCTI

Before 2026, U.S. shareholders of controlled foreign corporations were subject to tax on Global Intangible Low Taxed Income (GILTI) at an effective rate of 10.5 percent. The OBBBA changed the name to Net CFC Tested Income (NCTI) and cut the deduction from 50 percent to 40 percent, pushing the effective rate to 12.6 percent. It also eliminated the exemption for a deemed 10 percent return on tangible assets (QBAI) and reduced the haircut on foreign tax credits from 20 percent to 10 percent. These changes apply to taxable years beginning after December 31, 2025. Penn Wharton Budget Model, Law firm analysis

FDII becomes FDDEI

The deduction for Foreign Derived Intangible Income (FDII) drops from 37.5 percent to 33.34 percent, raising the effective rate from 13.125 percent to 14 percent. The QBAI component also disappears. Bloomberg Tax, Tax analysis

BEAT rate increases

The Base Erosion Anti-Abuse Tax (BEAT), which applies to large corporations with average gross receipts above $500 million and substantial deductible payments to foreign affiliates, increases from 10 percent to 10.5 percent. Tax Foundation analysis, Tax alert

When an AI company with foreign subsidiaries is acquired, the buyer must model the post acquisition effective tax rate on the combined global earnings. A small change in the statutory deduction can meaningfully alter the valuation. The Penn Wharton Budget Model estimates the international changes will reduce corporate tax revenue by $276 billion over the decade from 2026 to 2035. Penn Wharton Budget Model

What did the One Big Beautiful Bill Act change for AI M&A?

The OBBBA touched several provisions that change the numbers in an AI deal. Here is a summary of the most important ones, with effective dates.

Research and development expensing. Section 174A, effective for 2025 forward, allows full immediate deduction of domestic R&D. Small taxpayers can retroactively expense 2022 through 2024 domestic R&D. This should result in improved after tax returns for R&D intensive acquisition targets, potentially driving higher valuations. Law firm analysis

Qualified small business stock. The section 1202 exclusion cap per issuer rises from the greater of $10 million or ten times basis to the greater of $15 million (indexed after 2026) or ten times basis. The asset threshold for the issuing corporation rises from $50 million to $75 million. Stock issued after July 4, 2025 gets a tiered holding period. A shareholder who holds for three years can exclude 50 percent of gain, for four years 75 percent, and for five years 100 percent. Stock issued on or before that date keeps the old rules. The Tax Adviser

Bonus depreciation. Permanent 100 percent bonus depreciation is restored for most tangible property acquired after January 19, 2025. RSM

Business interest deduction. The section 163(j) limit is set permanently at 30 percent of EBITDA. For tax years after 2025, income from controlled foreign corporations is excluded from the adjusted taxable income base, which may reduce interest deductibility for multinational buyers. RSM

International provisions. Renamed and recalculated GILTI, FDII, and BEAT as described in the previous section.

Proposed reorganization documentation rules. Proposed regulations under section 368 would require parties to file a single comprehensive written plan of reorganization with their returns. The plan must describe every step, the business purpose, and the intended tax treatment. There would be a presumption that the plan is completed within 24 months of the first step. These regulations are not final. If adopted as proposed, they would add significant administrative burden to tax free deals. RSM US

Plan for the plan. If the proposed 24 month completion presumption becomes final, every tax free reorganization will need to be documented with more formality and tracked against a timeline. Early failure to file the plan could jeopardize the tax free treatment.

Key takeaways

• Map the deal structure early. The choice between taxable and tax free determines basis step up, NOL usage, and seller’s tax.
• In a taxable asset deal, allocate purchase price carefully among section 197 intangibles (15 year amortization) and shorter lived assets.
• Use the OBBBA retroactive section 174A election to undo prior year R&D capitalization and restore QSBS eligibility for qualifying AI startups.
• Commission a section 382 study for any AI target with significant NOLs. Many startups have already triggered ownership changes and their NOLs may be severely limited.
• Treat accelerated equity vesting as a potential golden parachute payment and plan for a shareholder vote to avoid the section 280G excise tax.
• Model the post 2025 NCTI and FDDEI rate increases if the target has international operations.
• If the deal is a tax free reorganization, start preparing a written plan that meets the proposed regulation’s standard even before it is final.

Frequently asked questions

Q:What is a tax free reorganization?

A:A tax free reorganization is a merger or acquisition structure that meets the requirements of section 368. In a typical stock for stock deal, the seller’s shareholders do not recognize gain at closing. They carry over their basis into the acquirer’s shares. The acquirer takes a carryover basis in the target’s assets. Common types include the Type A merger, Type B stock for stock, and Type C stock for assets.

Q:How does the OBBBA help AI startups with R&D costs?

A:The OBBBA added section 174A, which restores the ability to deduct domestic research costs immediately, starting in 2025. It also lets small companies go back and fully deduct the domestic R&D they were forced to capitalize during 2022 through 2024. This can reduce prior year tax bills through refund claims and, critically, shrink the asset base for QSBS testing. EisnerAmper

Q:What is QSBS and why does it matter in an AI acquisition?

A:QSBS stands for qualified small business stock under section 1202. If an individual holds QSBS for more than five years before selling it, they can exclude a large part of the gain from federal income tax, up to 100 percent. For AI founders and early investors, this can save millions of dollars on a company sale. The OBBBA raised the thresholds and added a tiered holding period for stock issued after July 4, 2025. The Tax Adviser

Q:Can a buyer use the target’s NOLs after an AI acquisition?

A:Yes, but the annual use is capped under section 382 if the target had an ownership change. The cap is generally the value of the target’s stock times the long term tax exempt rate. Many startups trigger ownership changes during funding rounds, so the usable amount may be far less than the face amount of the NOLs. Plante Moran

Q:How long does a buyer have to amortize acquired AI models?

A:If the AI models are acquired as part of a taxable asset deal, they normally fall into Class VI or VII under section 1060 and must be amortized over 15 years under section 197, using the straight line method. If a model is separately acquired software meeting certain tests, it may be depreciated over a shorter period. 26 U.S.C. §197, 26 U.S.C. §167

Q:What is the golden parachute tax in a startup acquisition?

A:Section 280G imposes a 20 percent excise tax on individuals who receive excess parachute payments from a change in control. It also denies the corporation a deduction. Accelerated vesting of equity can push a founder’s total deal payments above the safe harbor of three times their average salary, triggering the tax. A shareholder vote can exempt the payments for a corporation whose stock is not readily tradeable on an established securities market, whether the vote occurs before or after the payment is made. Treas. Reg. § 1.280G-1

Q:How do international tax rules change for an AI company after OBBBA?

A:The OBBBA increased the effective tax rate on foreign earnings starting in 2026. GILTI became NCTI with a 12.6 percent rate, up from 10.5 percent. FDII became FDDEI with a 14 percent rate, up from 13.125 percent. These changes raise the tax cost of foreign income for U.S. multinationals. Tax Policy Center

Q:What is a section 338(h)(10) election and when is it used?

A:It is an election made jointly by a corporate buyer and the seller of an S corporation or a consolidated subsidiary. It treats a qualifying stock purchase as a deemed asset sale, giving the buyer a stepped up basis in the target’s assets while the seller recognizes one level of tax. It is not available if the buyer is a partnership or an individual. 26 U.S.C. §338

Q:Do state taxes conform to the federal QSBS exclusion?

A:Not all states conform. Alabama, California, Mississippi, New Jersey, and Pennsylvania do not follow the federal QSBS rules. New Jersey plans partial conformity starting in 2026. A seller should check state specific exclusions before counting on a fully tax free exit. Legal analysis

Q:When did the new QSBS rules take effect?

A:The OBBBA QSBS changes apply to stock issued after July 4, 2025. Stock issued on or before that date remains under the old rules. The Tax Adviser

Q:What is the R&D tax credit and how does it apply to AI companies?

A:The section 41 research and development credit can offset federal income tax for a wide range of AI activities, including model development, algorithm design, and custom data pipelines, if the work meets a four part test. It must serve a permitted purpose, rely on the hard sciences, eliminate technical uncertainty, and involve a process of experimentation. Customer facing AI products qualify under the normal test. Internal use software must satisfy a stricter high threshold of innovation test. 26 CFR § 1.41-4(c)(6), The Tax Adviser

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Junde Liu, JD, LL.M. (Taxation) candidate at UF Law. Originally published on Compute Law Blog. This article is general information and does not constitute legal advice. Reading it does not create an attorney client relationship. The reader should not act on the basis of any content here without first consulting a licensed attorney in the relevant state. Last reviewed for accuracy May 23, 2026.