Last Updated on 06/16/2026
R&D Tax Credit for Software Development
Has your company invested in creating or improving software? You may be eligible for the research and development tax credit, a dollar-for-dollar reduction in federal tax liability. The credit applies to both commercial software products and proprietary internal tools, and it can translate into significant cash savings for reinvestment in your engineering team.
What Software Development Activities Qualify?
Many software companies underestimate the range of activities that can qualify for the R&D tax credit. The credit is not limited to breakthrough innovation; incremental improvements to existing software can also qualify.
Product development and engineering.
Designing new software architectures, building AI and machine learning models, developing mobile applications, and prototyping IoT firmware all commonly qualify. So does creating SaaS platform features that require solving technical challenges around multi-tenancy, access control, or performance.
Infrastructure and DevOps.
Migrating systems to cloud infrastructure, designing CI/CD pipelines, building automated testing frameworks, and optimizing application performance can all meet the threshold, provided they involve technical uncertainty.
Security and integration.
Engineering cybersecurity solutions, building custom API integrations, and developing data processing platforms for large-scale analytics are also frequently qualifying activities.
The activity does not need to succeed. What matters is the presence of technical uncertainty and a systematic process of experimentation, not the outcome.
The Four-Part Test
To qualify under IRC Section 41, software development activities must satisfy all four components of the IRS four-part test:
- Permitted Purpose. The activity must relate to a new or improved business component, targeting improvements in quality, function, reliability, or performance.
- Technological in Nature. The work must rely on principles of computer science, engineering, or another hard science. The techniques must be new to the taxpayer, even if similar solutions exist elsewhere.
- Eliminating Uncertainty. The development must address technical uncertainty related to methodology, capability, or design.
- Process of Experimentation. The taxpayer must evaluate alternatives through prototyping, simulation, modeling, or systematic trial and error.
The elimination of uncertainty and process of experimentation components receive the most IRS scrutiny, making thorough documentation of these elements especially important.
Internal Use vs. External Use Software
The IRS applies different qualification standards depending on how the software is used.
External use software: sold, leased, or licensed to third parties, is evaluated under the standard four-part test.
Internal use software (IUS): used for administrative functions such as HR or accounting, must also pass the high threshold of innovation (HTI) test. The HTI test requires the software to be innovative, involve significant economic risk, and not be commercially available without substantial modification.
Software serving both internal and external purposes requires careful classification. The IRS has increased scrutiny of IUS claims, and detailed guidance is available in TD 9786.
What Doesn't Qualify?
The following activities are generally excluded: research in social sciences or humanities, market surveys, work performed outside the U.S., research funded by another party, routine maintenance and bug fixes, deploying off-the-shelf software, and cosmetic changes that involve no technical uncertainty.
For the full list, refer to the IRS Form 6765 instructions.
How Is the Credit Calculated?
Most companies use the Alternative Simplified Credit (ASC), which provides a credit equal to 14% of qualified research expenses (QREs) that exceed 50% of the taxpayer’s average QREs over the prior three years. Companies with no prior history can claim 6% of current-year QREs. QREs include employee wages for qualified research, supplies, and 65% of contract research expenses.
Use the KBKG R&D Tax Credit Calculator to estimate your potential benefit.
For startups
Qualified small businesses with gross receipts of $5 million or less and no more than five years of history can apply up to $500,000 per year in R&D credits against FICA taxes.
Use the KBKG Payroll Tax Credit Calculator to estimate your payroll tax offset. Many states also offer their own R&D credits, some of which are refundable.
Visit the KBKG state R&D tax credit page for details.
Section 174 and Software Development Costs
Since 2022, the Tax Cuts and Jobs Act requires taxpayers to capitalize and amortize Section 174 research expenditures over 5 years (domestic) or 15 years (foreign), rather than deducting them immediately. This significantly impacts software companies that historically expensed these costs in the year incurred.
While Congress has considered restoring immediate expensing, no legislation has been enacted as of this writing. Software development costs subject to amortization may still generate R&D credits in the year incurred, but the cash flow dynamics change. Modeling both Section 174 and Section 41 together is essential to understanding the net impact on your tax position.
Documentation and IRS Compliance
The IRS expects contemporaneous records that substantiate both qualifying activities and expense calculations. Key documentation includes payroll records with time allocation, project descriptions with technical objectives, source code commit logs, and records of the uncertainties addressed during development.
Beginning with tax year 2025, Form 6765 Section G requires taxpayers to classify the type of software development at filing. KBKG provides audit defense support for companies facing IRS examination of their R&D credit.
How KBKG Can Help
KBKG’s R&D tax credit team combines deep technical expertise with a structured, compliance-focused methodology. Our specialists identify qualifying activities, calculate the credit, build supporting documentation, and prepare for potential IRS examination. We understand the technical substance behind your engineering work, and we know how to translate it into a defensible, maximized credit.
See if you qualify for tax credits, deductions, or cost recovery services by requesting a proposal.