Industry Focus
R&D Tax Credit for Software and Technology Companies
Introduction
Many software companies qualify for the R&D tax credit even though they don't consider themselves research organizations. The federal R&D tax credit is a generous incentive for companies that invest in designing new or improved products, processes, software, techniques, or technologies. And software and technology companies are in a sweet spot for eligibility, though many remain unfamiliar with the credit and its potential impact on their tax bill.
The R&D tax credit, which was enacted in the 1980s to incentivize innovation in the U.S., can directly reduce a company’s tax bill dollar for dollar. While it is generally a non-refundable credit used to offset income taxes, some early-stage companies can use the credit to offset payroll taxes.
Why Software Companies Qualify
The R&D tax credit is calculated based on Qualified Research Expenditures (QREs), which can include:
Wages paid to employees involved in R&D
Payments to contractors or vendors providing R&D services
Materials used in R&D that aren't capitalized or depreciated
Payments for cloud-based development environments or resources
To count as a QRE, an expense generally must be tied to an activity that:
Takes place within the U.S.
Attempts to design a new or improved product, process, software, formula, technique, or technology
Involves technological research (computer science, engineering, etc.)
Attempts to eliminate uncertainty about the appropriate design, methodology, or capability
Uses experimentation to evaluate one or more alternative solutions
Common Qualifying Activities
In today’s environment, innovation fuels the software and technology industry. Many activities undertaken by software and technology companies as they develop new and improved programs and features naturally meet the R&D tax credit criteria and qualify as QREs. Software engineering activities that typically qualify:
Developing functional specifications
Performing requirements, scope, and domain analysis
Designing new software architecture and algorithms
Creating source code
Performing unit, integration, performance, and regression testing
Developing internal or customer-facing software applications
Developing mobile applications
In many cases, most of the wages paid to the engineering department will qualify as QREs. A portion of the wages paid to the product, quality, and similar departments will also often qualify as QREs.
The R&D tax credit also applies to software developed by non-technology companies. Companies that invest in custom client portals, quote-generation engines, e-commerce platforms, servicing and delivery systems, and similar applications can benefit from the R&D tax credit regardless of the industry.
How the R&D Tax Credit Works
The federal R&D tax credit is one of the most lucrative tax incentives out there. Generally, it is worth between 5% and 10% of eligible QREs. The larger a company’s investment in innovation and R&D, the larger its R&D credit.
Many states also offer their own R&D tax credit for QREs incurred within that state. The value of state R&D tax credits varies widely but generally ranges between 3% and 15% of eligible state-specific QREs.
In addition to current year R&D tax credits, companies can often claim R&D tax credits from up to three years in the past, providing an avenue to recoup previously paid taxes.
Examples of Software R&D
SaaS Company
Challenge: developing a new platform architecture.
Potential qualifying activities: backend development, performance improvements, security enhancements.
Software Product Company
Challenge: creating new features.
Potential qualifying activities: prototype development, testing approaches, technical problem-solving.
Internal Software Team
Challenge: building proprietary systems.
Potential qualifying activities: automation tools, internal platforms, process improvements.
Documentation Requirements
The R&D tax credit is claimed on a company’s income tax return. Before making a claim, companies must analyze their projects and activities against the R&D tax credit rules. There’s a certain level of documentation required to successfully claim the R&D tax credit, and companies that claim the credit incorrectly could be subject to penalties.
How Firestone Helps
Many software and technology companies forgo this benefit because of misconceptions: that they need to develop groundbreaking technology to qualify, or that pre-profitability startups can't benefit. Firestone specializes in cutting through that confusion, using a no-risk, three-step process (Investigate, Calculate, Document) tailored to how you run your business.
Read about our process →
Working with your CPA
Technology clients are often a challenge for general accounting firms, but that's exactly where Firestone specializes. Firestone works alongside your existing tax advisor to identify opportunities and provide specialized R&D documentation, handling the technical analysis so you remain the trusted advisor. We don't provide tax preparation, assurance, or accounting services, so there's never any overlap with your core work.
Learn About Our CPA Partnership Program →
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Yes. Platform development, backend work, and performance/security improvements commonly qualify.
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Yes, including pre-revenue startups, which may be able to offset payroll taxes with the credit.
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Yes. Internal tools and platforms can qualify the same as customer-facing software.
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In many cases, most engineering department wages qualify as QREs.