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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.
IRS Research Credit Overview
IRS Software Process of Experimentation Guidance
IRS ATG Qualified Research Expenses
26 CFR 1.41-4 Regulation
Rev Proc 2000-50 PDF
Section 174 Notices (Example IRB)
Form 6765 (Current)

Evaluate Your Opportunity

We help scope initiatives, apply pragmatic documentation, and coordinate with tax professionals to optimize eligible value.
Discuss potential qualifying workSoftware development services

Frequently Asked Questions

Common questions about claiming R&D tax credits for software development projects and qualified research expenses.
Qualifying software must involve technical uncertainty and experimentation to develop new or improved functionality. Examples include custom algorithms, performance optimization, new integrations, novel user interfaces, or solving technical challenges. Routine customization or configuration typically doesn't qualify, but innovative solutions to business problems often do.
The federal credit is typically 6-14% of qualified expenses for most businesses. Many states offer additional credits of 5-25%. For a $100,000 qualifying software project, total credits could be $15,000-30,000. Credits can offset tax liability or, for qualified small businesses, be refunded even without tax owed.
Essential documentation includes project plans, technical specifications, testing records, time tracking, code repositories, and evidence of experimentation. Document the business purpose, technical challenges, alternative approaches tried, and how uncertainty was resolved. Contemporaneous records are crucial - don't recreate documentation after the fact.
Yes, both internal employee costs and contractor expenses can qualify, with some limitations. Internal costs include salaries, benefits, and supplies for qualified research. Contractor costs are limited to 65% of amounts paid unless the contractor is your employee or related party. Cloud computing and software tool costs may also qualify if directly used for experimentation.
Section 174 requires capitalizing software development costs over 5 years (15 years for foreign development) starting in 2022, but this doesn't affect R&D credit eligibility. You can still claim credits for qualifying activities even while capitalizing the costs. The timing difference means credits may be realized before full cost deduction.
Qualified research must eliminate technical uncertainty through experimentation. Regular development like standard features, routine fixes, or adapting existing solutions typically doesn't qualify. The key test is whether you're creating new knowledge or capability through systematic investigation. Custom solutions addressing novel technical challenges often qualify.
Absolutely. Small businesses can often receive refundable credits even without current tax liability. The Payroll Tax Election allows qualified small businesses to apply up to $250,000 annually in R&D credits against payroll taxes. This provides immediate cash flow benefits for growing companies investing in innovative software development.

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