Most Software Development Qualifies for R&D Tax Credits
Key Takeaways
- Most software development qualifies for the R&D tax credit, though some activities, such as routine maintenance and work performed outside the United States, do not.
- Qualifying activities span development, IT planning and design, supervision, and quality assurance and testing.
- Each activity still has to meet the four-part test under Section 41 to count as qualified research. See applying the four-part test to software development.
- Startups with less than $5 million in gross receipts, within their first five years of receipts, can apply the credit against payroll taxes (FICA).
- Strong records, payroll and ledger detail, project notes, commit logs, and documented uncertainties, are what support a software claim if it is examined.
I spend a lot of time speaking to founders and entrepreneurs about Research and Development (R&D) Tax Credits (IRC § 41). While these folks are exceptionally talented technologists and business operators, most have never heard of this tax credit or have wrongly assumed that they did not qualify and/or could not use software tax incentives, putting them at a disadvantage. Often, the misconception is further compounded by their receipt of incomplete, or partially inaccurate, advice from other business professionals.
The truth is that most software development (there are some exceptions) qualifies for research and development tax credits. Below are a few checklists to help you understand what types of activities can qualify for R&D tax credits from both federal and state governments. Understanding and identifying which initiatives and related expenses are considered “Qualified Research Expenses”, or QREs, is the first step towards claiming your credit.
When it comes to qualified research activities and tasks for R&D purposes, you might find the following tasks:
Software R&D Development
- Developing or improving an existing software; for commercialization or internal use
- Programming and testing source code
- Developing feature enhancements
- Creating new or specialized technologies
- Improving performance and optimizing functionality
- Creating, designing, and developing software architecture
Information Technologies Planning & Design
- Discovering and analyzing the specific functional requirements
- Attending meetings for technical purposes
- Analyzing the function of new software end requirements
- Prototyping user experience (UX) and user interface (UI) design
- User research and user testing
Supervision & Testing
- Technical project and product management
- Executive guidance and oversight of R&D projects
Quality Assurance & Testing
- Conducting unit, integration, functional, or regression testing
- Conducting performance or load testing
- End-to-end application testing and user acceptance testing (UAT)
Ready to reduce the tax you owe? For start-ups to be eligible to apply R&D tax credits against payroll tax liabilities (FICA), your company must also:
- Have less than $5 million in gross receipts for the current tax year
- Have no more than five years of gross receipts
If you do not qualify under these two stipulations, the credits can still be used against federal, and potentially, state income tax liabilities.
Records and Documentation Necessary to Support Your Claim:
- Payroll records
- General ledger expense details
- Project lists
- Project notes/tasks
- Software commit logs
- Email records
- Build/release notes
- Patent filings and issued patents
- Employee interviews/testimony
- Organizational charts
- Documented project uncertainties
- Methods and alternatives researched
- Records of testing performed and errors encountered
What Does Not Qualify for R&D Credits?
Although a majority of software developers' time is considered to be qualified, per the IRS, there are still some activities and tasks that do not qualify for R&D tax credits. Below is a list of those activities:
- Social sciences, arts, or humanities
- Surveys or market studies
- Any activities conducted outside the United States
- Research funded by another person or entity
- Routine maintenance and support (bug fixes)
- Configuration of software and/or use of turn-key solutions (e.g. deploying a licensed content management system (CMS) or Ecommerce platform)
With an experienced team like the one at Strike Tax R&D Advisory, your company will have the expertise required to support the intricate requirements needed for IRS approval of R&D Tax Credit claims. We'll even help you develop processes, like utilizing GitHub commit logs for documentation, to make claiming credits as simple as possible. You could even qualify for tax credits if you're a startup with losses.
We provide unlimited examination support if the claims are ever challenged. Contact us today to get a clear understanding of where you stand and how to claim tax incentives for your software.
Software development is just one of many industries that benefit from R&D tax credits. For a complete overview of R&D tax credit eligibility and the four-part test, see our complete guide to the R&D tax credit.
Frequently Asked Questions
Yes. Most software development qualifies, from building and improving software to programming, testing, and architecture work. The main exceptions are routine maintenance, configuration of turn-key solutions, and work performed outside the United States.
Common qualifying activities include developing or improving software, programming and testing source code, building feature enhancements, prototyping and UX or UI design, technical project oversight, and quality assurance testing such as unit, integration, performance, and user acceptance testing.
Routine maintenance and bug fixes, configuration or deployment of licensed turn-key software such as a content management or ecommerce platform, surveys or market studies, research funded by another party, work in the social sciences, arts, or humanities, and any activity conducted outside the United States.
Yes. A startup with less than $5 million in gross receipts for the year, and no more than five years of gross receipts, can apply the credit against payroll tax liabilities (FICA) even without income tax to pay. Companies that do not meet those tests can still apply the credit against income tax.
Helpful records include payroll and general ledger detail, project lists and notes, software commit logs, build and release notes, documented project uncertainties, and records of testing performed. Strong contemporaneous documentation is what supports the claim if it is ever examined.
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