Does Software Development qualify for the R&D Tax Credit?

The short answer

Yes, Software Development often qualifies, provided the work meets the same Four-Part Test as any other research: it has a permitted purpose (a new or improved function, performance, reliability or quality), it relies on computer science or engineering, it involves technical uncertainty at the outset, and you resolved that uncertainty through a process of experimentation such as prototyping, testing and iterating on alternatives.

Work that typically qualifies

• Designing new system architecture, data models or integrations where the approach wasn't known in advance
• Developing new algorithms, including machine learning models, matching, pricing or optimization logic
• Improving performance, scalability, latency or security beyond what known methods could achieve
• Building new product features that required evaluating technical alternatives
• Integrating disparate systems where compatibility, data integrity or throughput was uncertain

Work that usually doesn't

• Routine bug fixing and maintenance after commercial release
• Cosmetic or purely design changes with no technical uncertainty
• Configuring or customizing off-the-shelf software in standard ways
• Data entry, content creation and routine testing for quality control
• Market research, user surveys and business analysis

The extra test for Internal-Use Software

Software developed mainly for your own back-office functions, such as finance, HR or general administration, is Internal-Use Software. As well as the Four-Part Test, it must meet a high threshold of innovation:

• Innovative: it would produce a substantial and economically significant improvement, such as a reduction in cost or an increase in speed.
• Significant economic risk: you committed substantial resources with real uncertainty about whether it could be built or completed in time.
• Not commercially available: you couldn't simply buy or adapt existing software to do the job.

Software you sell, license or provide to customers, or that lets third parties interact with your systems, isn't treated as internal-use and doesn't face this extra test. Software that serves both purposes has its own allocation rules.

Which costs count

• Wages of developers, Engineers, testers and the managers directly supervising them, for time spent on qualifying work
• Contractors: generally 65% of amounts paid to US-based contractors for Qualifying Research, provided you bear the risk and retain rights to the results
• Cloud computing: amounts paid for the right to use computers, such as cloud hosting used for development and testing environments, can qualify
• Supplies used and consumed in the research

Research conducted outside the United States doesn't qualify, so offshore development teams are excluded.

Pre-revenue? Use it against Payroll Tax

Qualified small businesses with gross receipts under $5 million can apply up to $500,000 a year of the credit against employer Payroll Taxes, so early-stage software companies can benefit before they have taxable income. Read our guide to the R&D Payroll Tax Credit.

Frequently asked questions

This article is general information, not tax, legal or accounting advice. Tax rules change and outcomes depend on your specific facts; speak with a qualified tax professional before acting.