Software development is an innovative field; devs transform business operations and create products driving productivity and efficiency across industries.
Many don’t know that most software development companies can qualify for the federal R&D tax credit, providing significant saving opportunities for a range of businesses.
Most expenses that your software development company incurs during research and development are eligible for the R&D tax credit, including employee wages, cloud services, contractor expenses, and more.
Plus, software startups can also often benefit from the R&D tax credit by applying it toward their payroll tax liabilities — with a couple of stipulations that we’ll discuss later.
Let’s dive into the R&D tax credit to help you determine if your software development company is missing out on substantial tax savings!
Related: SR&ED Tax Credit Guide
Table of Contents
Does Your Software Development Company Qualify for the R&D Tax Credit?
Software companies can claim this tax incentive on projects where they improve or develop products or processes to improve performance, reliability, quality, or functionality.
So how do you know if your business qualifies?
Worried about missing out on your software company’s biggest refund? Combine the power of AI tax software with our R&D tax credit experts — Get started here!
Examples of Software Development Activities that Qualify for the Credit
Many of your research activities are likely eligible for the R&D credit, including:
- Creating and testing source code
- Optimizing performance and functionality of a software
- Improving or developing software — whether it’s for commercial or internal use
- Designing and developing architecture
- Working on feature improvements
- Creating new technologies
- Prototyping UX or UI designs
- Attending technical meetings
- User testing and research
- Analyzing functional requirements
- Project and product management
- Conducting load testing and other QA processes
There are endless activities that can allow software companies to claim the R&D tax credit; it’s impossible to list all of them. Luckily, the IRS established specific guidelines to help businesses determine their eligibility.
The R&D activities you perform must:
- Have a Qualified Purpose
The research your software company performs must aim to improve or create:
- Formulas
- Processes
- Products
- Other business components
In addition, that research should aim to enhance at least one of the following:
- Function
- Quality
- Reliability
- Performance
- Eliminate Uncertainty
Your company’s R&D must work to eliminate uncertainty in its business to qualify — but what does that mean?
The uncertainty must relate to the services or products you offer; marketing, advertising, etc., do not count. In addition, if you can eliminate the uncertainty by following a process that’s already established, that activity would not qualify.
For example, if switching to a new cloud service or creating a new spreadsheet in Excel solves your problem, it would not meet the IRS’ definition of qualified activity.
- Include Experimentation
Your research must also use the process of experimentation, whether it’s through trial and error, running simulations, creating models, creating multiple design iterations, etc.
The important part of this requirement is that your activities evaluate alternative solutions to solve your company’s uncertainty.
- Be Technological
The experimentation process you use must rely on hard science to qualify.
Hard sciences include:
- Computer science
- Physics
- Engineering
- Chemistry
- Biology
You can learn more about this four-part test here.
Related: 2023 Guide to Tax Incentives
In addition, the IRS defines the following as qualifying research activity expenses:
- Employee Wages
Typically, the largest expense a software development company has that qualifies for the R&D tax credit is its employee’s wages.
To qualify, the employees must do one of the following:
- Engage in a qualified research activity
- Support a qualified research activity
- Supervise a qualified research activity
- Supplies Used
Any tangible, non-depreciable property used in your qualifying research can also count toward your R&D credit; however, you must use the supplies directly for the research.
This category typically makes up the smallest amount of a software development company’s credit — depreciable property, intangible expenses, and land or land improvements do not qualify.
- Contracted Research
Finally, research that you contract out to other experts can also qualify for the R&D tax credit — between 65% and 75% of your expenses — as long as you meet a few conditions.
Other than passing the four-part test discussed above, the contracted research must meet the following criteria:
- Your software company must retain the rights to all results of the research.
- Your software company must pay for the research expenses even if the activities were unsuccessful.
- Your software company must enter into an agreement with the contractor(s) prior to starting research.
You can learn more about qualified research expenses here.
How Can a Software Development Startup Qualify for the R&D Tax Credit?
If your startup isn’t profitable, it’s not paying income taxes yet — so how does an income tax deduction help?
It doesn’t. However, most software startups are unaware that they can use the R&D tax credit against their payroll taxes instead.
If your startup is developing a product, creating software, or hiring programmers, that work likely qualifies for the tax incentive program.
In addition to passing the four-part test and following the above-listed guidelines for what counts as qualified research, a startup must meet two additional criteria to use the R&D tax credit to offset their payroll tax liability:
- You must have under $5 million in gross receipts the year you claim the credit.
- You must have no interest income or gross receipts for over five years before this tax year.
You can learn more about R&D tax credits for startups here.
How Can I Claim the R&D Tax Credit for My Software Company?
Claiming the R&D tax credit is easy; the challenge lies in evaluating and documenting your research activities that qualify to ensure you don’t miss out on any of the credit or include unqualified research.
You must file Form 6765 with the IRS and include documents that provide evidence that you qualify for the credit, including expense details, research results, payroll records, project notes, etc.
But filing for and claiming your R&D tax credits doesn’t have to be difficult with a little help from TaxRobot. Our AI-powered tax software makes getting the biggest refund easy — let us see if you qualify, fill out your research information, and collect your credit!
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Related: Maximize Your Return on Form 6765