R&D Tax Credits: Does Software Development Qualify?

Software companies, SaaS business, and companies with in-house developers could be leaving significant federal tax credits unclaimed under the Internal Revenue Code (IRC) §41. Though the code is nuanced and requires a careful interpretation, if your company is developing new features, solving technical problems, or iterating on back-end architecture with no guaranteed outcome, there is a possibility that you may qualify.

‍

‍

The Four-Part Test

‍

Every R&D tax credit claim begins with the same four-part test under the IRC §41(d). For software companies, each prong has direct application to how your developers work.

‍

1. Permitted Purpose: The research must be intended to develop a new or improved business component. IRC §41(d)(2)(B) expressly includes computer software as a business component, along with products, processes, techniques, formulas, and inventions.

‍

Software development or improvement efforts may satisfy the qualified-purpose prong when they relate to new or improved function, performance, reliability, or quality, such as speed, throughput, scalability, uptime, crash recovery, data integrity, or new functional features.

‍

2. Technological in Nature: The work must rely on principles of a hard science: physical sciences, biological sciences, engineering, or computer science. Under Treas. Reg. §1.41-4(a)(4), computer science and software engineering explicitly satisfy this requirement.

‍

3. Technical Uncertainty: At the start of the project, there must be genuine uncertainty about the capability of developing the software, the appropriate methodology for doing so.

‍

The IRS does distinguish between technical and commercial uncertainty. Technical uncertainty asks whether your team faced a genuine, computer-science-grounded question about how to build this that could not be resolved by simply reading documentation or applying known methods. Commercial uncertainty, however, asks if you knew at the start whether customers would buy it, which does not count.

‍

Capability uncertainty refers to whether your team genuinely doubted if a proposed feature or system could be built at all given technical constraints. The key is that the uncertainty must have existed at the outsight R&D, not in hindsight.

‍

4. Process of Experimentation: The research must involve identifying the uncertainty, identifying one or more alternatives to resolve it, and systematically evaluating those alternatives through modeling, simulation, or trial and error. See Treas. Reg. §1.41-4(a)(5)(i). For software, this maps directly to how iterative development actually works.

One important nuance: not all software development phases qualify for the credit. Design, coding, review, and pre-release testing are typically qualified activities, but post-release maintenance, routine bug repairs to already-released software, patch releases, and support and operations work are generally performed after commercial production has begun [IRC §41(d)(4)(A)].

‍

‍

Software Projects and How They May Qualify

‍

Software for Sale, Lease, or License

‍

If your business develops software to sell, license, or otherwise market to customers, you are dealing with the most favorable treatment. This software is not considered internal-use and is subject to the standard four-part test. SaaS platforms, commercial applications, and anything your paying customers access directly will all fall into this category.

Software for a Service

‍

This category covers software developed to support a service your business provides to customers. This can include a customer portal, an order tracking system, or a platform that allows third parties to initiate functions or review data on your system.

‍

Under Treas. Reg. §1.41-4(c)(6)(iv), software that enables a taxpayer to interact with third parties or allows third parties to initiate functions or review data is specifically excluded from internal-use software treatment, meaning this is subject to the four-part test.

‍

Internal-Use Software

‍

Software developed primarily for your own general and administrative functions faces a higher bar. Under IRC §41(d)(4)(E) and Treas. Reg. §1.41-4(c)(6), this software must satisfy the standard four-part test, but also a three-part High Threshold of Innovation Test. The IRS defines general and administrative functions as financial management, human resource management, and support services like data processing, facilities, marketing, legal, and compliance.

‍

The three-part High Threshold of Innovation Test requires:

• Innovation: The software would result in a substantial and economically significant reduction in cost, improvement in speed, or other measurable improvement if development succeeds.

‍

• Significant economic risk: Substantial resources were committed to the development and there was substantial uncertainty, due to technical risk, that those resources would be recovered within a reasonable period. Design uncertainty alone is not enough here; the uncertainty must relate to capability or methodology.

‍

• Not commercially available: The software cannot be purchased, leased, or licensed for the intended purpose without modifications that would themselves satisfy the innovation and economic risk prongs.

‍

If your internal tool could have been built by purchasing and lightly configuring existing software, if likely will not meet the final piece of the test. If your team built something genuinely novel because nothing on the market could do what you needed, it may qualify.

‍

Contracting Development

‍

Companies that develop software under contract for government entities or other companies also have additional considerations involving economic risk and intellectual property rights. The important question is whether the client, not the government, retains the rights to the software, or shares in those rights. Government contracts often include Federal Acquisition Regulation (FAR) and Defense Federal Acquisition Regulation Supplement (DFAR) clauses that address IP ownership and funding terms. A qualified R&D Tax credit professional needs to review these agreements carefully before determining what costs can be included in a claim.

‍

‍

New in 2025 and 2026: AI Assisted Development

‍

AI has changed the landscape of software development, and it’s imperative to be thorough when a company is working with coding agents to develop new software features. When working with an AI coding agent, the activity can certainly meet the four-part test, particularly when the work involves technical iteration and not simple prompting.

‍

The key is to identify the iterative development process. If a developer is using AI coding tools to generate candidate implementations, evaluates outputs against technical requirements, identifies failures, revises, and repeats, that is a process of experimentation grounded in computer science. The challenge is documentation: because these processes can be faster than traditional software development, it’s important to keep records of what was tested and why, and what the outcomes were, even if those are simple notes.

‍

‍

What Actually Counts as a QRE in Software

‍

Beyond identifying qualifying activities, determining which costs associated with said activities are eligible as qualified research expenditures (QREs) under IRC §41(b).

‍

Wages

‍

Wages paid to employees for qualified services are generally the primary QRE category for software businesses. Qualified services include directly performing qualified research, directly supervising it, or directly supporting it. Under Treas. Reg. §1.41-2(d)(2), if substantially all an employee's time consists of qualified services, the full wage is includable. Otherwise, only the allocable portion counts.

‍

Employees whose wages can commonly include qualifying time:

‍

- Software developers and programmers

- Software architects

- Software engineers

- QA engineers and testers performing pre-release testing

- Network engineers working on development related infrastructure

- Project/program managers directly supervising qualifying development

‍

Cloud Hosting and Computer Rental

‍

This category is often overlooked by software businesses when filing for R&D tax credits. Under IRC §41(b)(2)(A)(iii), amounts paid for the right to use computers in the conduct of qualified research are includable. Cloud hosting can include AWS, Azure, Google Cloud, and similar platforms used as development and testing environments.

The important distinction is staging versus production environments. Development and testing environments used to validate features before release are generally qualifying activities, whereas production environments hosting commercially released software for end-users are not.

‍

Contractor Costs

‍

Under IRC §41(b)(3), 65% of amounts paid to third parties for qualified research performed on the taxpayer’s behalf is includable as QREs. If your business uses outside developers, freelance engineers, or staffing firms to augment your development team on qualifying projects, a portion of those payments may be eligible.

‍

It should be noted that contractors working outside of the U.S. do not qualify as all activities are required to be performed inside the U.S.

‍

Contract review for your contractors is vital here; burden of economic risk and rights to intellectual property will both have an impact on if costs are eligible here, making an R&D tax credit expert essential.

‍

‍

What Does Not Qualify

A few activities that typically will not qualify for claim inclusion:

- Post-release maintenance and bug fixes after the beginning the commercial production.

Note: This is distinct from fixing critical errors causing crashes or timeouts in a development context, which may qualify.

- Minor updates and feature tweaks. Minor enhancements and iterations may qualify, but must each be evaluated against the four-part test.

- Adaption, i.e. implementation of an already built CRM and configuring it to your company’s needs without genuine technical uncertainty.

- Funded research under contract by a customer or government entity, regardless of outcome.

- Activities outside of the United States, even if supervised by U.S.-based employees.

Note: U.S.-based employees who directly supervise or support foreign development teams can include that supervisory time.

- Social sciences and business analysis such as research in economics, business management, market analysis, and behavioral sciences are all excluded.

‍

‍

Documentation

‍

Though extensive, scientific record-keeping is not a make or break, there must be documentation of sorts in order to claim. This is where an R&D expert can help; they are trained to find qualified activities and compile documentation that stands up to IRS scrutiny.

‍

Some records that may help support:

‍

- Project-level records that describe what the team was trying to solve, what they didn’t know, and/or what could not be solved with existing methods.

- Architecture decision records, design documents, scope documents, and/or any wireframes available.

- Sprint plans, product backlogs, and/or user story records.

- Bug trackers and issue logs that show iterative problem-solving.

- Version control history and logs showing development cycles.

- Time records for employees directly tied to R&D activities.

- Cloud billing records that show staging environment costs.

- Contracts with customers and development contractors.

‍

Because software development moves fast, finding records of all of your company’s activities may seem overwhelming, but again – this is where a qualified, experienced R&D tax credit partner is crucial, as they can help organize your notes into a compliant claim.

‍

‍

The One Big Beautiful Bill Act Deadline: Why Software Companies Should Act Now

‍

The OBBBA reinstated immediate expensing of domestic research and experimentation costs under new IRC §174A. This reversed the five-year amortization requirement under the Tax Cuts and Jobs Act (TCJA) that had been in place.

IRC Section 174A(d)(3) states that amounts paid or incurred in connection with the development of any software are treated as research or experimental expenditures. Section 174A(d)(3) continues to treat amounts paid or incurred in connection with the development of any software as R&E expenditures. The IRS previously took the position that, because software development closely resembled R&E activity, it would not challenge taxpayers' treatment of such costs as deductible R&E expenditures.

‍

For businesses averaging $31M or less in annual gross receipts under IRC §448(c), there is a retroactive election available to recover those previously amortized costs for tax years 2022 through 2024 by filing amended returns. The filing deadline is July 6, 2026, or the applicable statute of limitations for the year in question, which comes first. This is why it is imperative to start the process now.