Application of the 4 Part Test to Software Development
Key Takeaways
- Software development is one of the most common qualifying activities for the R&D tax credit, but each project still has to pass the four-part test under Section 41.
- The four parts are permitted purpose, technical uncertainty, process of experimentation, and being technological in nature.
- Both new software builds and later version improvements can qualify, and the work does not have to succeed to count.
- The technical uncertainty only has to be new to your company, not new to the industry.
- Internal-use software must also clear a separate three-part High Threshold of Innovation Test, which we cover in the internal-use software guide.
When conducting an R&D tax credit study, one of the first things any consulting firm will do is determine whether their client’s work meets the 4-part test requirements laid out in IRC Section 41. When it comes to software development, this test is extremely important, as it helps companies rapidly assess which aspects of their product development will qualify.
Although the IRS is very particular about what is defined as qualified research activities (QRAs), software development is one of the most common industries to qualify for the R&D tax credit. For the broader question of which software activities qualify, see our guide on why most software development qualifies for the R&D tax credit. This is why the four-part test analysis is so effective (and necessary) to perform at the beginning of the qualification process. The four requirements are summarized below.
Part 1: Permitted Purpose
Small businesses and startups that invest resources to design and develop new software can claim R&D credits. Additionally, investments to improve the software with new functionalities or capabilities are typically qualified research expenses (QREs).
For example, a company can claim R&D credits for developing the 1.0 version of a software platform, as well as the investment of time and resources into making enhancements for version 2.0 (and 3.0, etc.). Rarely does a company stop developing software after the first version, and the subsequent software development lifecycles (SDLC) also qualify.
Part 2: Technical Uncertainty
The project or development must attempt to resolve technological challenges or eliminate uncertainties. A technological uncertainty is applicable if the company’s available knowledge and information is insufficient or lacks depth to meet the software’s requirements and specifications. Software development fulfills this requirement since development teams do not know the optimal code design or coding methodology at the outset of the project.
Part 3: Process of Experimentation
A substantial part of the company’s activities undertaken to develop the software demonstrate a process of experimentation. That is, a series of trial and error designed to evaluate alternative solutions to achieve the desired permitted purpose. This can also include a regimented SDLC methodology and/or stage-gate process.
Part 4: Technological in Nature
The activities undertaken throughout the SDLC fundamentally rely on principles of the physical or biological sciences, engineering, or computer science; the last of which is the root of software development.
Internal-Use Software: An Additional Bar
Software built mainly for a company's own internal use must clear an extra three-part standard, the High Threshold of Innovation Test, on top of the four-part test above. Because internal-use software carries its own qualification rules and documentation needs, we cover it in depth in a separate guide. See internal-use software and the R&D tax credit for the innovation, economic risk, and commercial availability tests and how to document them.
If Your Company Is Developing Software, Chances Are It Qualifies
Software development is one of the fastest growing industries in the world, and companies developing software typically meet the 4-part test requirements. The primary issue companies face is accurately quantifying activities and expenses. This is where the experienced advisors at Strike Tax come in.
Let us help you generate additional funds to reinvest in your company, expand your workforce, and take your ideas to the next level. Contact us today to see how we can help, and use our credit calculator to see how much you could be saving toward your tax liability.
Frequently Asked Questions
No. Software development is one of the most common qualifying activities, but each project must pass the four-part test under Section 41. Routine or cosmetic changes, and work that involves no technical uncertainty, generally do not qualify.
Permitted purpose, meaning the work develops or improves a software product, process, or capability. Technical uncertainty, meaning the team does not know the optimal design or method at the outset. Process of experimentation, meaning alternatives are evaluated through trial and error or a structured development process. And technological in nature, meaning the work relies on computer science or other hard-science principles.
No. The work does not have to succeed, and the uncertainty only needs to be new to your company, not new to the industry. Failed, abandoned, or shelved projects can still qualify if the test was met when the work began.
It can, but internal-use software must clear an additional three-part standard, the High Threshold of Innovation Test, on top of the four-part test. See our internal-use software guide for how that test works and how to document it.
Common qualified research expenses include wages for employees who perform or support the development, a portion of payments to contractors who perform qualified work, and cloud or server costs tied to development. Quantifying these accurately is usually the hardest part of a software claim.
Related Articles
