If your company builds software — whether it’s a SaaS platform, a mobile app, an enterprise system, or internal tools — there’s a strong chance you’re sitting on unclaimed R&D tax credits. Software and internet companies represent 80.6% of all R&D credit claims and carry the lowest audit rate of any industry at just 5.28% (Boast 2026 Benchmark Report).
Yet many software companies — especially startups and mid-market firms — either assume they don’t qualify or have never seriously evaluated their eligibility. The misconception is that “R&D” means lab coats and beakers. In reality, if your development team is solving technical problems, testing approaches, and building things where the outcome wasn’t certain when they started, the IRS considers that qualified research.
But not all software work qualifies. And the IRS treats different types of software differently — especially when it comes to internal use software. Let me break down what counts, what doesn’t, and where software companies most commonly leave money on the table.
Key Takeaways
- Software companies file 80.6% of all R&D credit claims — more than any other industry — with a 5.28% audit rate (Boast, 2026)
- Software sold, leased, or licensed to third parties qualifies under standard rules, but internal use software must pass an additional three-part “high threshold of innovation” test
- Pre-revenue startups can apply up to $500,000 of R&D credits against payroll taxes under IRC §41(h) — even with zero income tax liability
- The OBBBA restored immediate expensing for domestic software R&D under Section 174A — reversing the painful 5-year amortization requirement that hit software companies hardest
Which Software Development Activities Qualify?
Software development activities qualify for the R&D credit when they meet the same four-part test that applies to all industries under IRC §41(d). The activities must involve technical uncertainty, rely on computer science or engineering principles, and involve a process of experimentation — testing, iterating, and evaluating alternatives.
For software companies, the four-part test translates into a straightforward question: when your developers started working on a feature, module, or system, did they already know exactly how to build it? If not — if they had to figure out the architecture, test different approaches, debug complex integration issues, or solve performance problems they hadn’t encountered before — that work likely qualifies.
Activities that typically qualify
Activities that don’t qualify
UI/UX design changes that are purely cosmetic (colors, layouts, branding). Routine bug fixes following established debugging procedures. Installing or configuring off-the-shelf software. Data migration using standard tools and documented processes. Training users on existing systems. Following a known tutorial or implementing well-documented patterns without technical uncertainty. Market research, user surveys, and A/B testing of marketing copy.
The Internal Use Software Trap: Why Classification Matters
Here’s where software R&D credits get complicated. The IRS doesn’t treat all software the same. Under Section 41(d)(4)(E) and Treasury Decision 9786 (issued 2016), the IRS defines four categories of software — and the rules for each are different.
Standard Rules Apply
Non-Internal Use Software
Software developed to be sold, leased, licensed, or marketed to third parties. Also includes software used in production processes or bundled with hardware as a single product. Qualifies under the standard four-part test.
Additional Test Required
Internal Use Software (IUS)
Software that supports general and administrative functions of the business (HR, accounting, internal operations). Must pass the additional three-part “high threshold of innovation” test to qualify for the credit.
Depends on Component
Dual Function Software
Similar to IUS but allows third parties to interact with the business’s systems (customer portals, client-facing features). Components enabling third-party interaction may be exempt from the high threshold test.
Standard Rules Apply
Excepted Software
Software used in otherwise qualified research activities (R&D tools), production processes, or as part of a hardware/software product. Exempt from the IUS restrictions even if used internally.
The high threshold of innovation test
If your software is classified as internal use software, it must pass a three-part test on top of the standard four-part test to qualify for the R&D credit:
The three-part high threshold of innovation (HTI) test:
| 1 | The software is innovative — the development results in a reduction in cost, improvement in speed, or other measurable improvement that is substantial and economically significant |
| 2 | The development involves significant economic risk — the taxpayer commits substantial resources and faces a real risk that the project may fail or not produce the intended result |
| 3 | The software is not commercially available — it can’t be purchased, leased, or licensed and used without significant modification |
Why this matters more than you think: The IUS classification trips up SaaS companies more than anyone. If you build a platform that customers use, that’s generally non-IUS — it’s software provided to third parties. But the internal admin dashboard, the billing system, and the internal analytics tools you built alongside it? Those might be IUS. The key is classifying each component correctly at the time of filing — and starting in 2025, the IRS requires you to identify software type on your return. Getting this wrong exposes the entire claim to challenge.
Where Software Companies Leave the Most Money on the Table
After working with software companies across the spectrum — from seed-stage startups to enterprise platforms — here are the three most common ways I see companies undercount their qualifying activities.
Undercounting Developer Time
Companies only count “coding” hours and miss the 30-40% of qualifying time spent in architecture design, code review, debugging, technical planning, and testing. The IRS includes direct supervision and direct support of qualified research.
Ignoring Failed Projects
That feature your team spent three months building and ultimately scrapped? If it involved technical uncertainty and experimentation, the development costs still qualify. The IRS doesn’t require success — only a genuine research process.
Missing Cloud/Supply Expenses
Cloud computing costs (AWS, GCP, Azure) used for development and testing environments can qualify as supply expenses. Many companies only claim wages and miss this entire cost category.
From our practice: The single biggest dollar amount we’ve recovered for a software client came from properly allocating QA engineer and DevOps time. The company had been counting only “feature development” hours and excluding everyone who wasn’t writing application code. But QA engineers testing for reliability and performance, and DevOps engineers building the deployment infrastructure, were all directly supporting qualified research. That time allocation adjustment alone increased their credit by over 40%.
The Startup Payroll Tax Offset: $500,000 in Real Cash Flow
This provision is made for software startups. Under IRC §41(h), qualified small businesses can elect to apply up to $500,000 of the R&D credit against their employer-portion Social Security taxes — even if they have zero income tax liability. For a pre-revenue SaaS company burning through cash on product development, this puts real money back into the business every quarter.
To qualify, you need gross receipts under $5 million for the credit year and no gross receipts in any tax year before the five-year period ending with the credit year. If your company is in years 1-5 and generating less than $5 million in revenue, you should be evaluating this every year.
How this works in practice: A seed-stage startup with $800,000 in annual developer payroll might have $60,000-$80,000 in qualifying R&D credits. They can’t use those credits against income tax because they have no income. But they can apply up to $500,000 per year against their payroll taxes — effectively getting a quarterly “refund” that reduces their cash burn. Over the five-year eligibility window, that’s up to $2.5 million in potential payroll tax offsets.
Section 174A: Why 2025 Is a Reset Moment for Software Companies
Legislative Update
No industry was hit harder by the TCJA’s Section 174 amortization requirement than software. Since 2022, companies had been forced to capitalize and amortize their domestic R&D costs over five years instead of deducting them immediately. For a software company where 60-80% of operating expenses are developer salaries, this created enormous taxable income — even when the company was barely profitable.
The OBBBA’s new Section 174A permanently restores immediate expensing for domestic R&D, effective for tax years beginning after December 31, 2024. For software companies, this means developer salaries, cloud computing costs for development environments, and contract development expenses are once again fully deductible in the year incurred.
What Software Companies Should Do Now
Deduct remaining 2022-2024 R&D costs
If you capitalized domestic R&D under the TCJA, you can deduct the remaining unamortized balance entirely in 2025 or split it across 2025-2026.
Evaluate retroactive election (small businesses)
Companies with average annual gross receipts under $31 million can apply Section 174A retroactively to 2022-2024 by amending returns. Deadline: July 6, 2026.
Separate domestic vs. foreign development costs
Foreign R&D expenses still require 15-year amortization. If you have offshore development teams, proper geographic allocation is critical — and it directly affects both your deduction and your credit calculation.
Documentation for Software R&D: What the IRS Wants to See
With Section G of Form 6765 becoming mandatory for 2026, software companies need to build documentation habits now. The IRS wants business component-level detail — not just “we spent X on development.”
For each qualifying project or feature, document these four things:
Pro tip: Your existing project management tools — Jira, Linear, Asana, GitHub — are goldmines for R&D documentation. Sprint planning notes, technical design documents, pull request descriptions, and commit histories all serve as contemporaneous evidence of uncertainty and experimentation. The key is mapping these to the four-part test framework before filing.
Building Software? You’re Probably Qualifying.
We’ll review your development activities, identify qualifying projects, and estimate your credit — at no cost. If you’re leaving money on the table, we’ll show you exactly how much.
Frequently Asked Questions
Does SaaS development qualify for the R&D credit?
Generally yes. SaaS products are typically classified as non-internal-use software (they’re provided to third-party customers), so they qualify under the standard four-part test. The development, testing, and iteration of your platform features are the primary qualifying activities. Cloud infrastructure used for development environments can qualify as supply expenses.
Can Agile/Scrum development qualify?
Yes. Agile methodology — with its iterative sprints, experimentation, and continuous testing — maps well to the four-part test’s process of experimentation requirement. Each sprint that tackles a technical challenge with an uncertain outcome can represent qualifying research activity.
Do offshore development team costs qualify?
No. Research conducted outside the United States is explicitly excluded from the R&D credit under IRC §41(d)(4)(F). Additionally, foreign R&D expenses must be amortized over 15 years under Section 174 (not eligible for Section 174A immediate expensing). If you have both domestic and offshore teams, proper allocation is critical.
We use contract developers — do their costs qualify?
Sixty-five percent of amounts paid to U.S.-based contract developers for qualified research performed on your behalf can be claimed as QREs. You must bear the financial risk and retain substantial rights to the resulting IP. If the contractor owns the IP or the arrangement is structured as funded research, the expenses may not qualify.
How much is the R&D credit worth for a typical software company?
Under the Alternative Simplified Credit, most software companies see an effective credit of 6-8% of qualifying R&D spending. For a company with $2 million in qualifying developer payroll and cloud costs, that’s roughly $120,000-$160,000 annually in dollar-for-dollar tax reduction. Read our complete R&D tax credit guide for calculation details.
What Should You Do Next?
Software companies have the highest adoption rate of the R&D credit for good reason — the qualifying activities align almost perfectly with everyday development work. If your team writes code, solves technical problems, and iterates on solutions, you’re likely performing qualified research right now.
The first step is a quick evaluation. Schedule a free consultation and we’ll walk through your development activities, identify which projects qualify, and estimate the credit value. We’ve helped software companies from early-stage startups to established platforms claim credits they didn’t know they were entitled to.
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Martin Gamez
Founder, Tax Formulations
Martin is a tax credit specialist with over 25 years of experience in federal and state R&D tax credits, cost segregation, and business tax incentives. His background includes tenure at Big Four and Top 10 accounting firms, with clients spanning technology, manufacturing, aerospace, engineering, and life sciences. Read full bio →