R&D Tax Credit for Software Development & Tech Startups

It’s estimated that software developers leave an average of $63,000 in R&D tax credits unclaimed each year.

Many tech and software startups overlook such credits due to misconceptions (i.e., assuming only lab-based R&D qualifies) or simply a lack of awareness. However, doing so is a major missed opportunity and forgoes significant financial benefits that can slow your startup’s growth.

Think of this post as a comprehensive guide to R&D tax credits. We’ll cover the four-part test, qualification criteria and the opportunity to offset up to $500,000 in payroll.

Understanding R&D Tax Credits

R&D tax credits are dollar-for-dollar credits that startups qualify for by performing activities related to development and design, or improvements to existing processes or products. Tax credits help directly reduce taxable liabilities, which can either help increase refunds or decrease the amount that you owe. R&D tax credits can affect both federal and state tax liabilities. Even startups that have yet to earn a profit can take advantage of R&D credits, notably when it comes to offsetting payroll tax.

R&D tax credits apply to more than just breakthrough innovations. In the case of a software startup, it may qualify for a development tax credit by improving software.

Why Software Companies Are Ideal R&D Credit Candidates

Software startups are ideal candidates for R&D tax credits because software development inherently involves problem-solving and experimentation — and most activities in the software development lifecycle qualify. As of 2024, it’s estimated that software developers have claimed over $2 billion in R&D tax credits, with the software and technology industries accounting for about 25 percent of all R&D tax credit claims.

That said, experts say that many eligible startups do not claim the credit.

The Four-Part Test for Software Developers

The Internal Revenue Service (IRS) uses a four-part test to determine eligibility — and it’s something that you should also use with your startup. Many software and tech developments tend to meet this criteria and qualify for such credits. Keep in mind that even unsuccessful projects can still qualify for the R&D tax credit.

Here’s a closer look at the four-part criteria:

Part 1: New or Improved Business Component

Does what you’re doing lead to the development of a new product, process or software, or the improvement of an existing product, process or software? Startups can check this box by enhancing a product or process’s capabilities. Even unsuccessful efforts can qualify, but intent must be present from the beginning.

Part 2: Technological in Nature

Can what you’re doing be described as technological?

Any research must rely on the principles of hard science and include engineering, physical science, biological science or computer science.

Part 3: Elimination of Technical Uncertainty

Was there ever any uncertainty about the method or outcome?

Your startup must intend to attempt to discover information that would eliminate uncertainty related to the development or improvement of a specific component. Uncertainty can involve appropriate design, capability or the method of development.

Part 4: Process of Experimentation

Was the development process experimental?

The activity must involve experimentation designed to resolve any uncertainty. There must be a systematic process of trial and error, hypothesis testing, and alternative evaluation. Common activities include modeling and simulation, testing, and iterative design and refinement.

Qualified Research Activities in Software Development

Beyond what the IRS assesses, some specific activities in software development qualify for R&D tax credits.

These include developing new software or enhancing existing software, prototyping and testing new functionalities, improving algorithms, coding, and software architecture, custom integration and solving technical challenges that generate qualified software development costs.

External Use Software (EUS) Development

External use software (EUS) is developed, sold or licensed. Under the IRS’ four-part test, EUS generally qualifies for R&D tax credits for eligible technology companies.

Internal Use Software (IUS) vs. External Use Software

In order to qualify for the R&D tax credit, it’s important to know the different rules and regulations as they pertain to internal use software and external use software. As the name implies, internal use software, or IUS, is mainly developed for internal use processes, and it must meet additional criteria to qualify for R&D tax credits.

For instance, IUS software must pass a three-part High Threshold of Innovation test to qualify, following the four-part R&D test. The three-part test for IUS involves assessing for innovation, significant economic risk and commercial availability.

Another consideration is dual-use software. Thanks to updated regulations released in 2016, dual-use software can qualify for R&D tax credits.

Some examples of qualifying IUS include ERP customization and proprietary tools.

Activities That Don’t Qualify

Various activities do not qualify for R&D tax credits. These include:

• Routine maintenance and bug fixes
• Configurations without code changes
• Cosmetic or stylistic updates

Calculating Your Software Development R&D Credit

How can you calculate your credit estimate? After passing the four-part IRS test, the next step is identifying your qualified research expenses and using either the Alternative Simplified Credit (ASC) or the Regular Research Credit (RRC) method. The ASC is a simplified calculation often used by startups, while the RRC is more complex but better suited for startups with high R&D expenses.

Qualified Research Expenses for Software Developers

What expenses count toward the R&D credit? Employee wages, contract research expenses, supplies and cloud computing costs are among the qualified research expenses for software developers.

If an employee spends at least 80 percent of their time on qualified research, their entire salary can be deducted. Up to 65 percent of the amount paid to any third-party contractors who perform qualified research on your behalf can also be deducted.

The Startup Payroll Tax Offset

If you’re a startup in a net operating loss (NOL) position, you can likely monetize R&D credits through payroll tax offsets. Startups with less than five years of income with less than $5 million in gross receipts may qualify for up to $500,000 worth of payroll taxes to be offset. This can provide immediate cash flow benefits for startups that have not turned a profit and can reduce overall income tax liability in future profitable years.

Documentation Requirements for Software R&D Credits

Documentation is everything when it comes to managing your financial portfolio. Tax documentation is a natural extension of this, both in terms of ensuring compliance and maximizing your opportunity to earn credits.

Good documentation practices include keeping detailed project descriptions, time logs and financial records related to qualified research expenses, using project management tools to keep track of R&D activities, and working with a professional if necessary to help maintain proper documentation.

Project Management Tools as Documentation

Consider leveraging existing tools, such as Jira and GitHub, for automatic documentation purposes. These tools centralize project details and help capture real-time information related to each task. They also create a history of your R&D efforts. Some best practices for effective R&D documentation include:

• Creating clear links between your financial costs and your documentation.
• Use templates to standardize the format for your documents.
• Clearly mapping out activities.
• Make it an activity to integrate documentation into your daily workflow.

Financial Documentation Requirements

Make sure you keep proper documentation of all activities related to R&D. This includes payroll records and time allocation, contractor invoices and statements of work, and supply and cloud service receipts.

Section 174 Amortization Rules and Impact

Section 174 requires startups to amortize any R&D expenditures, which can be complex and confusing.

Introduced with the Tax Cuts & Jobs Act in 2017, the section requires the amortization of R&D expenditures over five years for payments to domestic companies and over 15 years for payments to foreign companies. This can impact cash flow and deductions. Before the Tax Cuts & Jobs Act, R&D expenditures were listed as expenses in that respective taxable year.

Section 174 changes have created new options for startups. The One Big Beautiful Bill Act reversed the requirement for domestic R&D, restoring immediate expensing, meaning that startups can immediately deduct R&D expenses in the year they’re incurred which directly affects income tax liability calculations under current tax code guidance.

How to Claim R&D Tax Credits

Claiming R&D tax credits involves filing the appropriate forms with your startup’s annual tax returns. However, it can be challenging to navigate the process and identify all the expenditures that qualify. That’s why the first step in claiming R&D tax credits for many startups is engaging with a qualified CPA or tax professional. Such professionals can help perform an R&D tax credit study, identify the expenditures that qualify and file the appropriate forms to maximize the credits your startup can receive.

Additionally, coordinate with your startup’s payroll department or payroll providers and use tax credit software to look for payroll tax offsets.

The general steps for claiming R&D tax credits are as follows:

1. Meet the four-part IRS test.
2. Identify and document qualified research expenses.
3. Choose a calculation method (RRC or ASC).
4. File the necessary forms.

Working with R&D Tax Credit Specialists

Working with tax credit specialists for professional guidance can help ensure you maximize R&D credits and put more money back into your startup. Working with a professional can also help your startup stay in compliance and streamline documentation review in the event that it’s audited.

Common Misconceptions About R&D Tax Credits

Can only profitable startups claim R&D tax credits? Does only scientific research qualify? Is the application process complex?

The answer to these questions is “no.” In fact, these are some of the most common misconceptions about R&D tax credits.

No, profitable startups aren’t the only ones that can benefit. Startups that aren’t profitable can benefit, and they may even be able to take advantage of the payroll tax offset of up to $500,000.

No, scientific research isn’t the only thing that qualifies for R&D tax credits. Any expenditure related to your startup’s efforts to develop, design and enhance its own product or develop, design and enhance an existing product qualifies for the R&D tax credit.

Finally, no, the application process doesn’t have to be complex. It really comes down to ensuring that there’s proper documentation of all expenditures related to R&D and having general knowledge of the rules and regulations associated with it.

Maximize Your R&D Credits with Professional Guidance

If you want to maximize your R&D tax credits, consider working with a professional like Graphite Financial. At Graphite, we’ve helped hundreds of startups with their accounting needs. Our expertise also extends to helping startups navigate R&D tax credits while staying compliant with IRS regulations. We even offer personalized service to ensure we meet any unique startup needs.

Contact us today for more information and to schedule a free consultation.

FAQs

Do bug fixes and performance optimizations qualify for R&D tax credits?

No, standard bug fixes and routine performance optimization typically do not qualify for R&D credits. Performance optimization only qualifies for such credits if it’s part of a larger, experimental process that achieves a functional improvement.

Can software developers claim R&D credits for failed or abandoned features?

Yes, failed or abandoned features do qualify for R&D credits provided the development activities meet IRS criteria and the four-part test.

What percentage of a software developer’s salary typically qualifies for R&D credits?

This isn’t a fixed number — it’s largely based on the time spent on qualified research activities. The final amount is determined by the four-part test and time tracking. In some cases, the substantially all rule takes effect. If 80 percent or more of an employee’s time is spent on qualified research, the rule allows for 100 percent of that employee’s wages to be counted as a qualified research expense.

How do R&D credits work for contractors and freelance developers?

R&D credits can be claimed for eligible work, but eligibility depends on whether your startup retained the financial risk and substantial rights to the research. Work must also meet the four-part test for qualified research activities.

Can pre-revenue software startups benefit from R&D tax credits?

Yes, pre-revenue software startups can benefit from R&D tax credits through payroll tax offset provisions. The 2015 Protecting Americans from Tax Hikes Act created the payroll tax offset for eligible startups.

What’s the difference between software configuration and qualifying customization?

Software configuration modifies an application using built-in tools and features, while qualifying construction involves changing the source code to add new, specific functionality. Think of configuration as working within the existing software framework and customization as working outside of it.

How far back can software companies amend returns to claim missed R&D credits?

In most cases, software startups can amend federal tax returns to claim missed R&D credits for up to three previous tax years. Specific circumstances can also extend this period.

Do Agile and Scrum methodologies satisfy the process of experimentation requirement?

Yes, Agile and Scrum methodologies are based on experimentation, learning and adaptation.

Can we claim R&D credits for developing internal tools and automation?

Yes, but they’re subject to stricter qualification standards than software that’s developed for commercial sale. Any developed tools and automation must meet the IRS’ four-part test and also meet a three-part threshold of innovation for internal-use software.

How do recent Section 174 changes affect software R&D tax credits?

Section 174’s effect on software R&D tax credits has created new options for startups. Any R&D done domestically can be immediately deducted, which can help improve startup cash flow. Any non-domestic R&D, however, must be amortized.