Which Software Development Activities Qualify for the R&D Tax Credit?
Rohan Miller
Head of Tax Strategy
Software companies leave millions in R&D credits unclaimed because they assume only lab-coat research counts. The IRS definition is broader than most founders realize.
The IRS Four-Part Test for Software
IRC Section 41 does not have a separate standard for software. The same four-part test applies: permitted purpose (the work aims to create a new or improved business component), technological in nature (it relies on computer science, engineering, or a related discipline), technical uncertainty (you did not know at the outset whether the approach would work, how to achieve the desired result, or the appropriate design), and process of experimentation (you systematically evaluated alternatives through modeling, simulation, or trial and error). Software development qualifies when your engineers face genuine technical challenges, not just business requirements.
Activities That Qualify
Building a new product or platform from scratch where the technical approach is unproven almost always qualifies. Developing proprietary algorithms, data structures, or system architectures that go beyond combining existing libraries qualifies. Performance optimization work, where you are trying to meet specific latency, throughput, or scalability targets that require experimentation with different approaches, is eligible. Building integrations with third-party systems where the APIs are poorly documented, the data formats are inconsistent, or the failure modes are unpredictable often involves enough uncertainty to qualify. Developing automated testing frameworks for complex distributed systems is another common qualifying activity.
Activities That Do Not Qualify
Routine bug fixes where the solution path is obvious are excluded. UI design work that is aesthetic rather than technical does not qualify. Copying or adapting existing open-source software without meaningful modification is not R&D. Data entry, content creation, and business process configuration using established tools do not meet the bar. Moving an existing application from one platform to another using well-documented migration paths is generally not qualifying unless you encounter significant technical hurdles specific to your system.
How to Allocate Developer Time
Most engineers split their time between qualifying and non-qualifying activities. The IRS expects a reasonable allocation, not 100% across the board. We typically work with engineering managers to estimate the percentage of time each developer spends on qualifying work during each quarter. For a typical SaaS company, the qualifying percentage ranges from 40% to 70% of total engineering time. The allocation should be supportable, meaning you should be able to explain why a particular developer was at 60% rather than 80%. Sprint data, Jira tickets tagged by project type, and time tracking tools like Toggl or Harvest provide the evidence auditors look for.
The Section 174 Wrinkle
Starting with tax years beginning after December 31, 2021, Section 174 requires that research and experimental expenditures be capitalized and amortized over five years for domestic research or fifteen years for foreign research. This does not change whether you can claim the R&D credit, but it does affect the overall tax math. The credit is still calculated on current-year QREs, but the deduction for those expenses is now spread over five years. This interaction makes the R&D credit even more valuable on a relative basis, since the credit provides an immediate benefit while the deduction is deferred.
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