The Truth About R&D Tax Credits for Software Projects (With Real Examples)
Software companies can tap into immediate cash through R&D tax credit opportunities. Businesses that qualify can get back 6% to 8% of their yearly qualified expenses, which they can apply dollar for dollar against federal income tax liability.
Your organization could save hundreds of thousands—maybe even millions—of dollars since software development activities often qualify for these credits. The Inflation Reduction Act of 2022 made the R&D tax credit even better by doubling the maximum amount from $250,000 to $500,000 that qualifying small businesses can use against payroll taxes.
Software developers often miss out on these credits because they don’t know their daily work meets the IRS’s four-part test for qualified research. The test has sections on Permitted Purpose, Technological in Nature, Elimination of Uncertainty, and Process of Experimentation. Materials used in R&D can count toward your credit, but software developers rarely see this benefit. Most companies still receive up to 8 cents of credit for each dollar they spend on qualified expenses.
Let’s look at some real-life examples of R&D tax credits for software development. We’ll explain which activities qualify and show you the right way to calculate and claim this valuable credit for your business.
What qualifies as R&D in software development?
Software developers miss out on money they deserve because they don’t realize their work qualifies for R&D tax credits. Let’s get into what actually counts as qualified research in the software world.
Understanding the IRS four-part test
The IRS has a specific four-part test that determines if your software development activities qualify for the R&D tax credit. You must meet all these requirements:
Permitted Purpose: Your research must relate to a new or improved function, performance, reliability, or quality of your software. Small improvements can qualify too.
Technological in Nature: Your work must rely on principles of computer science, engineering, or other hard sciences.
Technical Uncertainty: You need to eliminate uncertainty about your software’s capability, methodology, or appropriate design.
Process of Experimentation: You should assess alternatives through modeling, simulation, or systematic trial and error.
Examples of qualified research activities (QRAs)
Common software development projects that qualify include:
Software development for sale, lease, or license
Original application software releases
Writing algorithms for fundamental computer processes
Database management techniques
Software systems architecture
Specialized technologies (AI, speech recognition)
Mobile applications and video games
Your projects don’t need to succeed to qualify. All but one of these projects that meet the four-part test count toward your R&D credit.
Internal vs external use software explained
The IRS makes a clear distinction between external and internal use software, with different requirements for each:
External use software is developed to be sold, leased, or licensed to customers. This type just needs to meet the standard four-part test.
Internal use software supports general administrative functions like finance, HR, or support services. So it faces a higher standard – the “high threshold of innovation” test, which requires:
The software is innovative with substantial economic benefits
Development involves significant economic risk
The software isn’t commercially available without modifications
All the same, some internal software doesn’t need this higher standard. This includes software used in qualified research activities, production processes, or as part of a hardware/software package.
Real examples of software R&D tax credit claims
These success stories show how R&D tax credits benefit software development companies of all sizes.
Case study: Cloud-based SaaS platform
A California-based cloud software company with just 15 employees and $6 million in annual revenue teamed up with Acena Consulting to identify qualifying R&D activities. The development team designed scalable REST APIs, created inventory management algorithms, and built fulfillment optimization systems.
The company secured about $2 million in qualified research expenditures. This led to a $200,000 federal R&D tax credit plus an extra $100,000 California state credit.
A SaaS innovator working with Smith + Howard received $840,000 in combined federal and Georgia state tax credits. Their previous provider missed a whole year of analysis. This shows how proper documentation and expert guidance can affect results by a lot.
Case study: AI model development
AI technology work often qualifies companies for substantial R&D credits. The four-part test typically approves activities like training, fine-tuning, or modifying AI models that meet specific business needs.
Companies can qualify even without modifying the core AI model. The proprietary software around it counts too. To cite an instance, building a custom retrieval system that increases generation with data pipelines and model management infrastructure counts as qualified research.
One pharmaceutical company utilized AI to accelerate protein folding and identify pharmaceutical candidates. Another company spent $1 million on software engineers, US-based contractors, and cloud computing services. This generated a $100,000 R&D credit.
Case study: Internal HR system upgrade
Recent regulation changes have opened up more opportunities for internal software systems like HR platforms that once faced strict qualification standards. A software development company earned a $69,265 cash rebate by documenting their step-by-step coding practices for internal systems.
The client needed only 3.5 hours to complete this claim. The project took just 33 working days from the original contact until they received funds. The company claimed another $51,052 the following year.
How to calculate and claim the R&D tax credit
The right calculation of R&D tax credit makes a huge difference in your returns. Software developers need to know their available methods to get the most tax benefits.
Regular credit vs alternative simplified credit (ASC)
You have two methods to calculate your R&D credit with the IRS. The regular credit method gives you a 20% credit on qualified expenses above a calculated base amount. This method could give you more money back, but you’ll need complex historical data from your company’s start – making it tough for many businesses.
The ASC method gives you a simpler way with a 14% credit on qualified expenses above 50% of your average QREs from the last three years. You can still get a 6% credit on current year expenses if you’re claiming for the first time without prior QREs.
Tax professionals suggest you should run the numbers both ways to see which method gives you better returns.
What are qualified research expenses (QREs)?
QREs fall into three main categories:
Wage expenses: Salaries paid to employees who directly conduct, supervise, or support qualified research
Supply costs: Tangible materials used during research that weren’t capitalized or depreciated
Contract research: 65% of payments to U.S.-based third parties doing research for you (75% for qualified research consortia)
How to use Form 6765
Form 6765 lets you claim your R&D credit with the IRS. You’ll need to fill out Section A for regular credit or Section B for ASC – not both. Remember to attach the form to your tax return filed on time, including extensions.
Payroll tax offset for startups
Small businesses that qualify can use up to $500,000 of their R&D credit against employer payroll taxes instead of income tax. Your company needs:
Less than $5 million in gross receipts for the current tax year
No gross receipts from more than five years ago
This option works great for pre-revenue startups because you can benefit from the credit even without owing income tax.
Common mistakes and how to avoid them
Software companies leave significant money on the table by making simple mistakes with R&D tax credits, despite their generous financial benefits. Learning about these common pitfalls will help your organization maximize its eligible claims.
Misunderstanding what qualifies
Many people wrongly think software development needs major scientific breakthroughs or trailblazing research to qualify. The tax code only asks you to find technological information your organization doesn’t already know. Your failed projects can qualify too, as long as they meet the four-part test. Companies often wrongly leave out:
Development of new features or improvements to existing platforms
Designing software for internal use that meets state-of-the-art standards
Projects that don’t result in a patent or completely unique product
Poor documentation practices
The Moore v. Commissioner case shows how things can go wrong. A manufacturer lost their R&D credit claim because they didn’t keep good records. They couldn’t separate qualified research time from non-qualified time and lacked contemporaneous records. You should implement:
Detailed project narratives that show objectives, uncertainties, and experimental methods
Precise employee time logs that connect hours to specific R&D projects
Accurate tracking of all research-related expenses with proper categorization
Note that rebuilding documentation during an audit becomes nearly impossible, which makes live record-keeping crucial.
Overlooking internal-use software eligibility
The belief that internal software projects don’t qualify is a common mistake. Internal-use software needs to pass the “high-threshold-of-innovation” test, but exceptions exist. Software doesn’t need this higher standard when it’s:
Used in qualified research activities
Used in production processes
Developed as an integral part of a hardware and software package
More importantly, software that makes shared third-party interactions or reviews possible isn’t considered internal-use and only needs to meet the standard four-part test.
Assuming only large companies qualify
Approximately 25% of companies claiming R&D credit have assets under $1 million. The PATH Act helps startups and small businesses benefit through:
Using credits against payroll taxes instead of income taxes
Allowing businesses with less than $5 million in revenue to claim credits
Enabling qualified small businesses to apply the credit against Alternative Minimum Tax
Companies without current tax liability can still benefit because federal credits carry forward for up to 20 years.
Conclusion
R&D tax credits give software companies a big but often missed chance to save money. Companies of all sizes can recover 6% to 8% of qualified expenses, which could mean hundreds of thousands or even millions in savings. You don’t need to create breakthrough innovations to qualify—the IRS accepts even small improvements to existing software.
Case studies show how this works on the ground. A 15-employee SaaS company got $300,000 in combined credits. An AI development firm earned $100,000 from $1 million in qualified expenses. These benefits are available to pre-revenue startups too, thanks to the payroll tax offset provision.
Software developers should look at their daily work through the lens of the four-part test. Your team’s work to solve technical problems likely qualifies, whatever the project’s outcome. Good documentation makes all the difference during an audit, so keep detailed records of your development process.
Both external and internal use software can qualify under the right conditions. Recent rule changes have created more chances for companies that develop internal systems, though different standards apply to each type.
Your software company can turn regular development work into valuable tax savings by knowing what qualifies, keeping proper records, and working with experts. The R&D tax credit isn’t just for big corporations or state-of-the-art breakthroughs—it rewards the technical problem-solving that software developers do every day.
