Software R&D Credit & Section 174
Software R&D Tax Credit (Section 41) & 174 Guide
See how qualifying custom development can earn the Section 41 R&D tax credit while Section 174 capitalization shapes cash flow, and why most off the shelf tools do not qualify.
Overview
Custom developed software can generate a dollar for dollar federal tax reduction via the Section 41 R&D credit when it meets qualified research tests, while those same costs must be capitalized and amortized under Section 174. Purchased or licensed generic software usually does not create credit value because your team is not performing the experimentation.
What Qualifies as Software R&D
A project must address technical uncertainty with an iterative process. Internal use software faces an added innovation threshold while external facing products apply only the core four part test.
- Four Part Test
- Technological in nature, eliminates technical uncertainty, improves a business component, and uses a process of experimentation (iteration, prototypes, testing).
- Internal Use High Threshold
- For internal platforms: substantial innovation, significant economic risk, and not commercially available without major modification.
- External Use Software
- Software sold, licensed, or marketed typically only needs the four part test.
Common Exclusions
Adaptation without uncertainty, cosmetic changes, post production support, market research, routine data collection, work done outside the United States, and funded research do not qualify.
Why Pre Built Software Usually Does Not Qualify
License and SaaS fees are acquisition costs. Your team did not run the experimentation loop so Section 41 criteria are not met. These costs follow standard software cost recovery rules such as Rev. Proc. 2000-50 or Section 167 depreciation.
Section 174 vs Section 41
Section 174 requires capitalization and amortization (5 year domestic, 15 year foreign, mid year convention). Section 41 can still produce a credit on those same qualified costs. Both regimes apply simultaneously when requirements are met.
Qualified Research Expenses (QREs)
Eligible cost buckets often include in house technical wages, qualifying supplies, cloud and compute usage tied to experimentation, and a percentage of contract research. Accurate time tracking and allocation underpin defensibility.
- Technical Wages
- Engineers, designers performing technical tasks, product and QA roles directly supporting experimentation.
- Supplies and Cloud Usage
- Tangible property and qualifying compute consumed during development and test cycles.
- Contract Research Portion
- Percentage of eligible subcontractor invoices (subject to statutory limits) can be included.
- Allocation Discipline
- Segregate qualifying build vs maintenance, configuration, data migration, and support.
- Lookback Opportunity
- Prior open years may be amended if you can substantiate missed qualified expenses.
How to Claim the Credit
A lightweight, repeatable workflow improves accuracy and lowers audit friction.
- Evaluate Eligibility
- Map initiatives against the four part test and internal use criteria where applicable.
- Capture Experiment Artifacts
- Preserve prototypes, alternative designs, test metrics, and decision notes.
- Track Time and Costs
- Attribute hours and resource usage to qualifying activities early.
- Segregate Non Qualifying Spend
- Separate licenses, routine support, and content/data cleanup tasks.
- Prepare Form 6765
- Compile qualified research expenses, apply elections, and document methodology.
- Apply Section 174 Rules
- Capitalize and amortize required software research costs in parallel.
- Involve Specialized Advisors
- External review strengthens methodology and claim defensibility.
Benefits of Building Custom
Dollar for dollar credit reduces tax, amortization smooths expense impact, and proprietary capability delivers strategic differentiation compared to generic tools.
References & Source Materials
Primary IRS and regulatory materials for deeper review.
Evaluate Your Opportunity
We help scope initiatives, apply pragmatic documentation, and coordinate with tax professionals to optimize eligible value.