The R&D Tax Credit for Software Developers

May 31, 2024

Introduction  

In the most recent year for which data is available, software developers claimed over $2 Billion in R&D Tax Credits.  

This tremendous incentive is a dollar-for-dollar federal Credit that can be claimed yearly and used to offset tax liability. The Credit allows firms to hire new employees, expand their technologies, and finance other business objectives. Some states have their own versions of the Credit, further boosting the possible benefit.  

If you own a software development firm or advise someone who does, you should know how to tap into this Credit.  

Why is Software Development Such a Good Fit for R&D Tax Credits?  

R&D is integral to software design and development – it’s all about problem-solving, and where you find problem-solvers, you’ll find R&D activity.  

These days, software firms range from tiny 2-person custom app shops to huge international conglomerates. Any developer may qualify for the Credit if they are creating or improving processes, systems, platforms, or portals. Eligible product types may include:  

  • Custom software intended for sale, lease, or license to customers (External Use Software) 
  • Internal Use Software (IUS – we’ll discuss in more detail below) 
  • Database/Document Management Systems 
  • Firmware 
  • Compilers 
  • Operating Systems  
  • Mobile Applications 
  • Video Games 
  • Artificial Intelligence 
  • Virtual Reality 
  • Augmented Reality  

How Can Developers Qualify for the R&D Tax Credit?  

 

Eligibility Criteria of R&D Credit

The R&D Tax Credit is an activities-based Credit, and most manufacturers qualify for the R&D Tax Credit just by performing their day-to-day activities. If you develop or improve a product or process, you likely perform Qualifying Research Activities (QRAs).  

To officially be considered a QRA, your activity must pass the IRS’ Four-Part Test. This is generally a very easy task for a manufacturer:   

PART I: New or Improved BusinessComponent: The activity must be related to developing or improving the functionality, quality, reliability, or performance of a business component

Developers create and improve products and processes in every stage of the Software Development Life Cycle – CHECK.  

PART II: Elimination of Uncertainty: The activity must be undertaken for the purpose of eliminating some uncertainty — 

  • Can I make a brand-new product? 
  • What will the new product design look like? How can I make it? 
  • Can I improve an old product? Is this even feasible? 
  • Can I improve the process by which the product is made? 
  • How can I incorporate new features and functions into an existing product/process? 

Another easy CHECK – questions like these are at the heart of custom software development.  

PART III: Process of Experimentation: The activity must involve some kind of experimentation designed to resolve the uncertainty, which may include:  

  • Evaluation of Alternatives 
  • Hypothesis Testing 
  • Systematic Trial and Error 
  • 3D Modeling or Simulations 

 A third CHECK – trial and error is intrinsic to the development process, which is iterative in nature

PART IV: Technological in Nature: The activity must be based on a hard science – engineering, physics, chemistry, etc.  

The final CHECK – that’s a 100% on this test.  

Internal Use Software (IUS)

Software developed with the intent to sell, lease, or license is considered “external” software.  That’s what most people think of when they think about software development, and that’s where we’ll focus the bulk of our attention. However, many firms develop software for internal use, generally for one of three purposes:  

  • Financial Management 
  • HR Management (payroll, billing) 
  • Support Services (MRP, ERP) 

Dual Use Software, which has both internal and external functionalities, is also considered Internal Use Software (IUS).  

IUS may also be eligible for the Credit, but it is subject to additional testing. The 4-Part Test discussed above isn’t enough.   

In October of 2016, final regulations clarifying the treatment of IUS were published. These regulations provided rules for putting IUS to an additional test, the 3-part “High Threshold of Innovation Test:” 

  1. The IUS must be innovative – it must target an economically significant reduction in cost, improvement in speed, or other measurable improvement  
  2. The IUS is not commercially available 
  3. The development of the IUS involves significant economic risk: 
    • Substantial resources have been invested by the taxpayer; and  
    • There is substantial uncertainty that those resources will be recouped within a reasonable time period, due to technical uncertainty  

The third part of this test is actually 2 parts, reflecting the combination of factors required to define significant economic risk.  

Clearly, claiming the R&D Tax Credit for IUS is more complicated than claiming the credit for external use software. If you’re interested in learning more about the unique regulations that define IUS eligibility, please contact us 

Which Activities in the Development Process Qualify for the R&D Tax Credit? 

Software is all about innovation and improvement – it’s no surprise that QRAs take place in each step of the Software Development Life Cycle: 

R&D Tax Credit-Chart

There are multiple approaches to software design, but whether you prefer the agile methodology, the linear waterfall system, or some other approach, there are qualifying activities embedded in each stage of the process.  

At this point, it’s instructive to distinguish between software configuration and software customization:  

  • Software configuration: activating or arranging the capabilities already in your system to best meet your needs. This doesn’t require changes to the code and is not a qualifying activity.  
  • Software customization: making an actual change to the software to add new functionality. This is a qualifying activity.  

In addition to software configuration, the following activities also do not qualify for the Credit:   

  • Development performed outside of the United States and US territories  
  • Developing software that replicates a procedure that used to be done by hand – simple automation of a process is not considered qualified activity  
  • Routine maintenance and production  
  • Post-release bug fixes and routine quality control testing  
  • User interface or experience development for purely cosmetic design  
  • Use of a “plug and play” generic turn-key solution (not customized in any way) 

What Costs Can Developers Claim Towards the R&D Tax Credit?  

Qualified Research Expenses (QREs) are expenses related to QRAs. QREs are the expenses that can qualify for the Credit, and they fall into 4 categories:  

  1. Employee Wages  
  2. Third-Party Contractor Payments  
  3. Cloud Hosting Expenses   
  4. Supplies and Materials  

Let’s look at the most common QREs more closely: 

Employee Wages:   

Employee wages are the largest QRE for software developers. Wages of those performing qualified activities may be claimed, as well as wages of those who directly support and supervise them. 

The “80% Rule” or the “Substantially All” Rule, is a taxpayer-friendly provision. If 80% of the work performed by an employee is related to QRAs, 100% of the wages paid to the employee may be captured as QREs and included in the Credit calculation.  

If less than 80% of an employee’s activities relate to QRAs, only a commensurate portion of that employee’s salary may be claimed. This is often relevant when considering the salaries of those who provide technical guidance and general oversight. 

The following job titles are illustrative of the types of positions eligible:    

  • Engineer (Analytics, Hardware, Integration, Network, Software) 
  • Architect (Database, Solutions) 
  • Developer (Front End, Full Stack) 
  • Programmer 
  • Software Analyst 
  • Beta Tester 
  • Project Manager 
  • Director of Operations  

Payments to Third-Party Contractors  

When companies are just starting out, they often employ outside contractors to fill any in-house skill or bandwidth gaps. Payments made to third-parties may be claimed towards the Credit, as long as the third-party is based in the US.  

One important note – only 65% of these payments may be claimed towards the Credit.  

Cloud Hosting Expenses:   

Cloud hosting fees may also be included in the Credit, when applicable to development or testing environments, but not for production.  

How Can Developers Claim the R&D Tax Credit? 

Software developers can claim the R&D Credit by filingIRS Form 6765, Credit for Increasing Research Activities.Taxpayers must provide “sufficient documentation” to support the amount of QREs they are claiming.  

The IRS does not specify what constitutes “sufficient documentation.” In general, the more documentation you can retain and provide as needed, the better. Here are some examples of helpful documentation:  

  • Payroll information for employees directly involved in R&D and for employees or managers supervising them  
  • Copies of contracts and invoices paid to third-party contractors  
  • Documents that demonstrate the research process and progress: design revisions, records of tests performed and errors identified, software commit logs, build/release notes, emails, presentations, meeting minutes, etc.  

Credible employee testimony is also helpful in substantiating the R&D Tax Credit claim, especially in conjunction with documentation.  

The high salaries of many software professionals may result in extra scrutiny when your Claim is evaluated. Additional documentation for highly compensated professionals is helpful when possible, and may include emails and calendar appointments relating to qualified activities.   

There is an additional documentation requirement established by Memorandum Number 20214101F, “Minimum Requirements for an R&D Claim.” This 2021 Memorandum states that for each product or process, the claimant must:  

  1. Identify all research activities performed;   
  2. Identify all individuals who performed each research activity; and   
  3. Identify all the information each individual sought to discover.  

In June of 2024, the IRS waived the requirement to provide the information referenced in #2 and #3.  However, in the event that a claim is selected for subsequent examination, the IRS may request that information. 

In short, you still need to be able to demonstrate who worked on what, when, why, and how, although you may not be called upon to “show your work.”

It’s crucial to select an R&D Provider who understands the documentation requirements for a claim to be successful. 

How Large Can the R&D Tax Credit Be for Developers? 

The amount of the Credit depends on the value of the QREs, not on company size or overall revenue. The significant salaries earned by many software professionals can result in substantial QREs, and a commensurately substantial Credit.    

The R&D Tax Credit offers up to 10 cents in benefit for every qualifying dollar identified in a study. Not everyone receives the full 10 cents for every dollar spent, but many software developers actually do.   

Imagine a small software firm – Firm SF — of 10 employees, each of which makes $100K annually. They’re all developers – SF hasn’t gotten big enough for lots of supervisors – and as such all their activity qualifies. Firm SF would have $1M in QREs, and could receive a maximum Credit of $100K.  

(And that’s only the federal Credit. If Firm SF is in a state like California, the benefit could double.)  

Eligible companies can also look back to prior year returns – usually the last three tax years — to see if they qualified for the Credit in those years as well. In 2024, Firm SF could claim the current year Credit, plus the Credit from 2023, 2022, and 2021, for a whopping $400K first year Credit.   

This $400K isn’t a deduction that decreases taxable income. It’s a Credit, so it directly reduces the amount of tax that must be paid by $400K.   

The icing on the cake is that this Credit can be carried forward for up to 20 years. If Firm SF continues to meet eligibility requirements, it can rely on a $100K Credit annually for up to two decades.  

What about Start-Up Software Firms That Aren’t Profitable Yet? 

The Payroll R&D Tax Credit is a modified version of the Federal R&D Tax Credit, created specifically for small businesses that do not yet have income tax liability. Created through the PATH Act of 2015, the Payroll R&D Tax Credit permits “Qualified Small Businesses” (QSBs) to claim up to $500,000 annually for tax years beginning after December 31, 2022. QSBs can use that credit to offset the 6.2% employer portion of the Social Security payroll tax under the Federal Insurance Contributions Act (FICA) as well as the 1.45% employer portion of the Medicare payroll tax liability ($250,000 towards each).  

For tax years prior to December 31, 2022, the maximum claim is $250,000 and the credit only applies to the social security tax.  

The Payroll R&D Tax Credit can be taken for up to 5 years, resulting in a potential total credit of $2.5M to apply against payroll taxes. This is a huge boon to software start-ups and smaller firms because the Payroll R&D Tax Credit can free up crucial capital needed to grow. 

To be considered a “Qualified Small Business,” you must: 

  • Have less than $5M in gross receipts for the year in which you wish to claim the credit; and 
  • Have no gross receipts for any tax year more than five years prior to the claim year 

What Should Developers Do Next?  

If you’re interested in learning more about how you might benefit, you need to consult an R&D Tax Credit provider. Your CPA might have a recommendation, or if you’re evaluating providers yourself, be sure to ask these important questions 

Claiming the Credit requires a strong understanding of software development and how the tax code applies. Your provider will be combing through your development process start to finish, identifying all QRAs and tying QREs to them. It’s important to select an R&D Tax Credit provider with the technical and tax knowledge required to do the job right.  

The Capstan team can review your situation in a 15-20 minute call to get a sense of your activities and expenses, and then provide a Credit estimate.  

We’re here to help.  

Safe Harbors in a Storm TPR Expensing Options
Determine R&D Tax Credit Eligibility - four part test

In the most recent year for which data is available, software developers claimed over $2 Billion in R&D Tax Credits.  

Sign Me Up

12 + 14 =

Recent Articles

Marketing: The Secret to Growing Your Firm?

Marketing: The Secret to Growing Your Firm?

Nine Ways to Get the Most Out of Your Marketing Department Hinge, a leading branding and marketing firm for professionals, recently released its 2023 High Growth Study. One notable takeaway – the difference between high-growth firms and medium-growth firms comes down...

Partial Asset Disposition

Partial Asset Disposition

Introduction   Welcome to the fourth and final post in our exclusive series on navigating the Tangible Property Regulations. If you’re ready to jump right in, read on.   If you need a brief refresher, take a moment to review posts on expensing options, the BAR Test,...

How to Claim the R&D Tax Credit for Manufacturers

How to Claim the R&D Tax Credit for Manufacturers

How to Claim the R&D Tax Credit for ManufacturersManufacturers claim the lion’s share of R&D Tax Credits annually – over $7.5B in the most recent year for which data is available.   This tremendous incentive is a dollar-for-dollar federal Credit that can be...