Published September 17, 2018 · Updated August 5, 2026
By Jonathan Tucker, Principal at KBKG
Software development is expensive, and many companies are unaware they are sitting on significant tax savings.
The federal and state R&D tax credits can return 6-15% of development costs as a dollar-for-dollar reduction in tax liability. This guide covers everything you need to know, including a key provision for startups that allows them to offset payroll taxes immediately.
Key Takeaways
- Software development activities may qualify for the R&D tax credit when they address technical uncertainty through a process of experimentation and meet the IRS four-part test.
- Eligible companies that develop software may claim qualified wages, contractor costs, supplies, and certain cloud-computing expenses, provided those costs are properly tied to qualifying development activities.
- KBKG’s R&D experts help companies apply a project-level qualification framework, identify defensible qualified research expenses, and build the documentation needed to support the credit. You can contact these specialists for a free consultation.
What Is the R&D Tax Credit for Software Development?
The Research and Development tax credit, established under Internal Revenue Code (IRC) Section 41, is designed to encourage innovation in the United States. For software companies, qualifying activities may include developing or improving software, products, processes, or other business components.
Software development does not need to result in a patented invention or a successful final product to qualify. Improvements to existing software, failed projects, and technical experimentation may still be eligible if the activities meet the required criteria.
- Incremental Improvements: Enhancements to existing software can qualify, not just brand-new technology.
- Failed Projects: Research activities qualify based on the process, even if the project ultimately fails.
- State Credits: Over 40 states offer their own R&D credits, which can be combined with the federal credit to increase savings.
How Startups Can Use R&D Tax Credits (Payroll Tax Offset)
The Qualified Small Business Payroll Tax Election
Certain qualified small businesses may be able to apply up to $500,000 of R&D credits per year against employer-paid payroll taxes. This can create a cash-flow benefit for startups that do not yet have income tax liability.
To qualify, a business generally must have gross receipts below $5 million in the current tax year and must not have had gross receipts in any tax year before the five-tax-year period ending with the current year under IRC Section 41(h).
Alternative Minimum Tax Offset for Small Businesses
Eligible small businesses may also be able to use the R&D tax credit to offset Alternative Minimum Tax, expanding the usefulness of the credit beyond regular income tax liability.
The Four-Part Test: Does Your Software Development Qualify?
KBKG’s proprietary R&D Qualification Framework evaluates development projects by connecting each element of the four-part test to the specific technical challenge, alternatives considered, experimentation performed, and resulting software improvement. This project-level approach helps distinguish qualified software development from routine maintenance, or implementation work.
Software development activities must satisfy the IRS four-part test to qualify for the R&D tax credit.
- Permitted Purpose
The research must be for the purpose of creating a new or improved business component. This means the work aims to enhance functionality, performance, reliability, or quality. The project does not need to be successful to qualify.
- Technological in Nature
The development process must fundamentally rely on principles of computer science or engineering. This test excludes research in the social sciences, arts, or humanities. Software development inherently involves applying technical principles.
- Elimination of Uncertainty
At the project’s outset, there must be technical uncertainty concerning the capability, method, or appropriate design of the business component. This uncertainty must be technical in nature, not commercial or financial. The goal is to discover information that eliminates this uncertainty.
- Process of Experimentation
The company must engage in a systematic process designed to evaluate one or more alternatives to eliminate the technical uncertainty. This can include modeling, simulation, systematic trial and error, or prototyping. Agile development methodologies often align with this requirement.
Software Development Activities That Qualify for the R&D Tax Credit
A wide range of software development tasks can be considered qualifying activities. The key is that they must be part of a process intended to resolve technical uncertainty.
Common Qualifying Activities
Examples of core development activities include:
- Developing new algorithms, machine learning models, or specialized technologies
- Designing and developing new software architecture, such as microservices or cloud-native systems
- Writing and testing source code as part of an experimental process
- Conducting integration, performance, or security testing to validate a new design
- Developing APIs and system integrations to connect disparate systems in a novel way
Types of Software Development That Qualify
The credit applies across various software categories, including:
- External-use software: Products intended for sale, lease, or license to third parties.
- Internal-use software: Tools developed for your own business operations (subject to stricter rules).
- SaaS/cloud applications: Subscription-based software delivered via the internet.
- Embedded software/firmware: Software that is a component of a hardware product.
- AI/ML systems: Development of training models, neural networks, and recommendation engines.
What Expenses Qualify for the R&D Tax Credit?
In KBKG’s R&D experts’ experience, the strongest credit calculations connect expenses to specific qualified projects rather than relying on broad departmental estimates. For software companies, that typically means separating qualifying development wages, contractor costs, and cloud-computing expenses from production support, routine maintenance, and other nonqualifying activities.
Qualified Research Expenses, or QREs, generally fall into several categories.
Qualified Wages
This includes W-2 wages for employees who perform, directly supervise, or directly support qualified research activities. Only the portion of wages corresponding to time spent on R&D is eligible. This applies only to work conducted within the United States.
For example, if a software company has $500,000 of current-year QREs, all from qualifying wages, and a $200,000 average of QREs for the prior three tax years, it could generate an estimated $56,000 federal credit under the Alternative Simplified Credit method described in the Form 6765 instructions.
Supplies
This category covers the cost of tangible supplies used or consumed during the research process. It does not include land or depreciable property. For software, this is often a minor expense category.
Contract Research
Generally, 65% of amounts paid to third parties for qualified research may be included, provided the taxpayer retains substantial rights to the research and bears economic risk.
- Inclusion Rate: Generally, 65% of contract research expenses are eligible.
- Key Requirement: Your company must retain substantial rights to the research results and bear the economic risk of the work.
Cloud Computing Costs
As of 2022, costs for cloud computing services used for qualified research are eligible expenses. This includes payments to providers like AWS, Azure, and Google Cloud for hosting development and testing environments. You must allocate these costs between qualifying R&D use and general production use.
Special Rules for Internal Use Software
Internal-use software is software developed primarily for a company’s own business operations. These projects must satisfy the standard four-part test and an additional three-part test.three-part test under Treas. Reg. Section 1.41-4(c)(6).
The Three-Part Test for Internal Use Software
To qualify, IUS must meet all of the following criteria:
| Test | Description |
|---|---|
| High Threshold of Innovation | The software must be highly innovative and result in a significant reduction in cost or improvement in speed that is not available in the commercial market. |
| Significant Economic Risk | The company must commit substantial resources to the development, and there must be considerable uncertainty of success due to technical risk. |
| No Commercially Available Alternative | The software is not available for purchase from a third party and cannot be acquired or modified to meet the company’s needs. |
Activities That Do NOT Qualify for the R&D Tax Credit
It is equally important to understand which activities are specifically excluded from the R&D tax credit. This helps set proper expectations and ensure compliance.
Commonly excluded software activities include:
- Research conducted after commercial production has begun
- Routine maintenance, testing, or bug fixing without technical uncertainty
- Adaptation or duplication of an existing business component
- Market research, surveys, or studies of management functions
- Research conducted outside the United States
Section 174: What Changed, What Applies Now, and When
Previous Law (effective for tax years beginning after January 1, 2022):
For tax years beginning after January 1, 2022, businesses were required to capitalize and amortize research or experimental expenditures. Domestic Section 174 costs were generally amortized over five years, while foreign R&D costs were amortized over 15 years.
New Law (enacted July 4, 2025):
Under current law and following the One Big Beautiful Bill Act (H.R. 1) enacted July 4, 2025, domestic R&D costs are once again generally deductible in the year paid or incurred for tax years beginning after December 31, 2024. Foreign research expenditures continue to be capitalized and amortized over 15 years. under Section 174.
- Domestic R&D: For tax years beginning after December 31, 2024, domestic R&D expenditures are once again fully deductible in the year paid or incurred.
- Foreign R&D: Foreign research expenditures remain subject to capitalization and 15-year amortization. No repeal applies to foreign costs.
Transition for 2022 through 2024 domestic costs already capitalized:
The legislation provides options to accelerate remaining unamortized domestic Section 174 costs from 2022 through 2024, commonly through a deduction in 2025 or spread across 2025 and 2026, depending on taxpayer facts and elections. Taxpayers meeting the Section 448(c) gross receipts test may have an option to retroactively apply the domestic expensing change for 2022 through 2024 through amended returns, subject to the specific statutory and procedural requirements.
How to Claim the R&D Tax Credit for Software Development
Claiming the credit involves careful documentation and filing the correct forms with your annual tax return. Proper records are essential to substantiate your claim in case of an IRS audit.
According to Jonathan Tucker, R&D Principal at KBKG, a supportable software R&D credit should tell a consistent story across both technical and financial records: what uncertainty the development team faced, which alternatives it evaluated, who performed the work, and how the related expenses were calculated. KBKG recommends documenting this connection throughout the development process rather than trying to recreate it only after the tax year has ended.
Documentation and Filing Checklist
| Step | Action Item |
|---|---|
| Document Projects | Maintain technical specifications, architecture diagrams, design documents, and meeting notes that show the experimental process. |
| Track Expenses | Keep detailed payroll records, timesheets, contractor invoices, and cloud computing invoices allocated to qualifying projects. |
| File Form 6765 | Complete and file Form 6765, Credit for Increasing Research Activities, with your annual tax return. |
| Consider Amendments | Review whether prior open tax years may be amended to claim missed R&D credits. |
Don’t Leave Money on the Table
If your company is developing software, you are likely eligible for substantial R&D tax credits. With proper documentation and expert guidance, software companies can recover a significant percentage of their development costs.
KBKG has helped hundreds of software companies—from early-stage startups to publicly traded enterprises—claim millions in R&D tax credits. Our team combines tax technical expertise with deep software industry knowledge to maximize your credits while ensuring audit-proof documentation.
Ready to explore your potential R&D tax credit?
- [Schedule a free consultation] with our R&D credit specialists
- [Use our R&D credit calculator] to estimate your potential benefit
Author: Tetyana Guguchkina, Principal at KBKG
1Treas. Reg. § 1.41-2 Qualified Research Expenses.
Frequently Asked Questions
Can pre-revenue startups claim the R&D tax credit?
Yes, qualified small businesses can apply up to $500,000 of their R&D credit against payroll taxes, providing an immediate cash benefit even without income tax liability.
Does routine bug fixing qualify for the R&D tax credit?
No, routine bug fixing does not qualify because the activity must be part of a process to resolve technical uncertainty to be eligible.
How far back can I claim R&D tax credits?
Businesses can generally amend open prior-year returns to claim missed R&D credits, commonly up to three prior tax years.
Do I need a patent to qualify for the R&D tax credit?
No, a patent is not required because the credit focuses on the development process and technical experimentation, not the final outcome.