Software R&D Tax Credit: Which Expenses Qualify in 2026?

Employee wages, founder compensation, contractors, foreign developers, and cloud costs: what software startups can actually include.

If your startup develops software, you may qualify for the federal R&D tax credit. But there's an important distinction: building software does not automatically make every development expense eligible.

For most software companies, qualifying expenses are primarily wages paid to U.S.-based engineers, certain founder compensation, and a portion of payments to domestic contractors. Some cloud computing costs may also qualify.

The IRS evaluates both the work being performed and the type of expense incurred.

Here's how to determine what counts for 2026.

01First, does your software development qualify as R&D?

Before calculating expenses, you need to establish that the underlying development activities qualify as research under IRC Section 41.

Generally, research must satisfy four requirements:

Qualifying research expenditures. The research must meet the applicable domestic research expenditure requirements under IRC Section 174A.
Technological nature. The research must seek to discover information based on principles of computer science, engineering, or another qualifying hard science.
Permitted purpose. The work must aim to develop or improve a product, process, or software component's function, performance, reliability, or quality.
Process of experimentation. Substantially all of the research activities must involve evaluating alternatives to resolve technical uncertainty.

For example, engineers testing several architectural approaches to improve a platform's performance under heavy transaction loads may be performing qualified research.

Adding standard features using established methods, making cosmetic interface changes, or performing routine maintenance generally does not qualify on its own.

A project can include both qualifying and nonqualifying activities. The company must distinguish between them.

What about new features added to an existing product?

Releasing a product does not permanently end its R&D eligibility.

Routine debugging and maintenance after commercial release generally do not qualify. However, subsequent development of a genuinely new or improved component may qualify if that work independently meets the research requirements.

021. Employee wages: usually the largest qualifying expense

For most software startups, employee compensation represents the largest portion of qualified research expenses (QREs).

Eligible wages generally include compensation subject to federal income tax withholding, to the extent it relates to qualified research services.

Three categories of employee activity can qualify.

Direct research

This includes engineers and developers actually performing qualified research, such as designing, coding, prototyping, and testing technological solutions.

Direct supervision

First-line engineering managers who directly supervise qualified research may qualify. Higher-level managers whose responsibilities are limited to supervising other managers generally do not qualify based on that supervisory work alone.

Direct support

Employees directly supporting qualified research may qualify. For example, personnel compiling experimental test data can qualify, while general administrative, payroll, and HR activities typically do not.

Do all engineering wages qualify?

No. The employee's job title is not enough.

Suppose a software engineer earns $160,000 annually and spends:

70% of their time developing and testing qualifying technology.
20% maintaining existing software.
10% on routine support and administrative activities.

Assuming the wage amount otherwise qualifies, approximately $112,000 could be included as qualified research wages.

There is also an IRS 80% rule. If at least 80% of an employee's services are qualified research services, generally 100% of that employee's eligible wages may be included.

Bonuses and certain taxable stock-based compensation may also qualify, but special rules apply. In particular, compensation recognized when stock options are exercised requires an examination of the services for which the options were granted. It should not automatically be included simply because it appears on Form W-2.

Employer payroll taxes and many nontaxable employee benefits are not qualified wages.

032. Founder compensation: can founders claim their own work?

Yes, founders who personally perform qualified research may generate eligible research expenses.

Consider a startup CEO who spends part of the year writing code, developing algorithms, or testing a new technical architecture.

That portion of their work may qualify, even if their title is CEO.

However, the founder needs to substantiate the time spent performing qualified research rather than fundraising, recruiting, managing the business, or developing customer relationships.

What if the founder takes little or no salary?

This is particularly important for early-stage C corporations.

If a founder works full-time developing software but receives no wages, the company generally has no qualifying wage expense attributable to that founder's unpaid work.

Founder equity ownership does not create qualifying wage expenses by itself.

Similarly, S corporation shareholder distributions are not qualifying wages. Compensation arrangements for partnership owners and self-employed individuals require separate analysis.

For founders receiving W-2 compensation, reasonable records should distinguish qualified engineering activities from executive and administrative responsibilities.

The IRS can challenge unsupported allocations even when a founder was genuinely involved in product development.

043. Contractors and development agencies: generally 65% of eligible costs

Many startups use independent developers instead of hiring employees.

Payments to qualifying contractors can be included in the R&D credit calculation, but generally only 65% of eligible contract research expenses count.

For example, if a startup pays $100,000 to U.S.-based independent developers and all the research and contractual requirements are satisfied, $65,000 may be included in QREs.

The full $100,000 is not included.

Contract research generally must be performed on the company's behalf. The company must have sufficient rights to the research results and generally must be obligated to pay for the work regardless of whether the research succeeds.

This makes contractor agreements important.

If a development agency retains the rights to the research or receives payment only upon successful completion, the arrangement requires closer examination.

A fixed-fee contract is not automatically disqualified, but the contractual terms and allocation of economic risk matter.

Companies providing custom development services to their own customers also need to evaluate whether their research is funded by the customer. Depending on the agreement, that work may be excluded.

054. Foreign developers: generally excluded from the federal R&D credit

This is one of the most important distinctions for startups with distributed engineering teams.

Under IRC Section 41, research performed outside the United States and qualifying U.S. territories generally does not qualify for the federal R&D tax credit.

This exclusion applies regardless of whether the individual is an employee or independent contractor.

For example:

Developer working in California

Wages attributable to qualifying research may be eligible.

Developer working in Poland

Research performed there is generally excluded, even if the developer is employed by a U.S. corporation.

U.S. citizen working remotely from another country

The employee's citizenship does not determine eligibility. The physical location where the research is performed matters.

Research performed in Puerto Rico or another qualifying U.S. possession is treated differently and is not excluded simply because it occurs outside the 50 states.

For employees who split their working time between locations, qualifying services and compensation need to be allocated appropriately.

Foreign software development expenses may still be deductible or capitalizable under other tax rules, but they generally remain subject to 15-year amortization under IRC Section 174.

That distinction is important: an expense can be subject to R&D tax accounting rules without qualifying for the R&D tax credit.

065. Cloud computing and AI infrastructure: what qualifies?

Software companies often incur significant cloud costs for development, testing, and AI model training.

Some of these expenses may qualify, but not every cloud bill is a qualified research expense.

IRC Section 41 permits certain payments for the right to use computers in qualified research.

The applicable rules generally require that the computers be:

Owned and operated by another party.
Located off the company's premises.
Used under an arrangement in which the company is not the computer's primary user.

For example, qualifying third-party computing resources used to test experimental algorithms or train and evaluate models during qualified research may be eligible, depending on the arrangement.

However, production hosting, ordinary software subscriptions, general business tools, and routine operational computing costs generally should not be treated as qualified computer rental expenses.

Cloud invoices should be separated between research environments and production operations.

Special attention is warranted for dedicated GPU clusters, reserved cloud instances, and similar arrangements. Whether these satisfy the computer rental requirements depends on the underlying facts, including how the equipment is operated and who primarily uses it.

AI development also must meet the same qualified research requirements as other software development. Training an AI model does not automatically make every associated expense eligible.

076. What other software development expenses usually do not qualify?

Not every cost booked to an R&D or engineering expense account qualifies for the credit.

Common examples of expenses or activities that generally do not qualify include:

Routine bug fixes and maintenance after commercial release.
Cosmetic UI changes and routine website updates.
Marketing, customer research, and product management unrelated to qualified research.
User manuals and routine technical documentation.
General software subscriptions and collaboration tools.
Depreciable equipment, such as laptops and purchased servers.
Foreign research expenses.
Customer-funded research, to the extent excluded under the funded research rules.

There is also a special rule for software developed primarily for a company's internal general and administrative functions.

Certain internal-use software must meet an additional high threshold of innovation test, involving substantial innovation, significant economic risk, and lack of a commercially available alternative.

Software developed for external customers generally is not subject to that additional internal-use software test. Certain other exceptions also apply.

087. Example: calculating qualified research expenses for a software startup

Consider a startup with the following annual spending:

$400,000 in U.S. engineering wages

Assume engineers spend 75% of their time on qualifying research.

Qualified wages: $300,000

$100,000 paid to U.S. contractors

Assume the entire contract qualifies under the research and contractual requirements.

Qualified contract research: $65,000

$80,000 paid to foreign developers

Research is performed outside the United States and its qualifying territories.

Qualified expenses: $0

$20,000 in production hosting

Assume the expenses relate entirely to operating an already released product.

Qualified expenses: $0

Total estimated qualified research expenses: $365,000

This amount represents the potential expense base used in calculating the research credit.

It is not the credit itself.

The federal R&D credit generally involves comparing current qualified research expenses with a historical base amount. Depending on the method used, the regular credit or alternative simplified credit may apply.

A company cannot simply multiply every qualifying expense by 20% and assume that is its credit.

098. Can a pre-revenue startup claim the R&D credit?

Yes. A startup does not necessarily need to generate revenue or have taxable income to benefit from the credit.

Qualified small businesses may elect to apply up to $500,000 of their annual federal research credit against eligible employer payroll taxes.

Generally, a business must have less than $5 million in gross receipts for the current tax year and no gross receipts before the five-tax-year period ending with the current year. Other eligibility rules apply, including aggregation of certain related businesses.

The payroll tax election can be made for no more than five tax years.

The election is made on a timely filed original income tax return, including extensions, using Form 6765. The credit is subsequently claimed against eligible employer payroll taxes using Form 8974 with the applicable payroll tax return.

For many early-stage startups, this payroll tax option makes the R&D credit valuable before the business becomes profitable.

109. What documentation does the IRS expect?

A credit claim needs to connect eligible spending to actual qualified research activities.

Simply reporting a large engineering payroll or providing a list of software developers is not sufficient.

Ideally, a startup should maintain:

Project descriptions identifying the technical uncertainty addressed and the experimentation performed.
Engineering tickets, sprint records, testing results, and code repository histories.
Reasonable employee and founder time allocations tied to qualified activities.
Payroll records and contractor invoices.
Contractor agreements showing research rights and payment obligations.
Records establishing where employees and contractors physically performed their work.
Cloud usage records distinguishing qualified research computing from production hosting.

Startups often already have much of this information in their engineering systems.

The challenge is organizing it in a way that supports the expenses claimed.

What changed for 2026 Form 6765 reporting?

For tax years beginning in 2026, Form 6765 Section G generally requires more detailed information about qualifying business components.

However, the IRS provides exceptions, including for certain qualified small businesses making the reduced payroll tax credit election.

Another exception generally applies to original returns where total qualified research expenses do not exceed $1.5 million and average annual gross receipts for the preceding three tax years do not exceed $50 million, subject to the applicable group rules.

For taxpayers required to complete Section G, the IRS generally requires business-component reporting covering at least 80% of QREs, up to 50 business components.

Even companies exempt from Section G must maintain records substantiating their research credit claims.

1110. How do the 2025 changes to Section 174 affect the R&D credit?

Beginning with tax years after December 31, 2024, IRC Section 174A generally permits immediate deductions for domestic research and experimental expenditures, including qualifying software development costs.

Businesses may alternatively elect to capitalize and amortize domestic research expenditures under the applicable rules.

Foreign research expenditures generally remain subject to 15-year amortization.

However, the Section 174A deduction and Section 41 R&D credit have different requirements.

A company may have software development expenses that are deductible under Section 174A but do not qualify for the R&D credit.

When a company claims the credit, IRC Section 280C also affects the related deduction. Companies generally must account for a deduction reduction or elect a reduced research credit.

These rules should be evaluated together when preparing the corporate tax return.

12How should software startups estimate their R&D credit?

Start with the projects and activities, then identify which expenses relate to qualifying research.

For most software startups, the largest potential qualifying costs will be employee wages and eligible domestic contractor payments. Cloud computing may contribute additional expenses in appropriate circumstances.

The important questions are how much time was actually spent on qualified research, where that research occurred, and whether the associated costs satisfy the IRS requirements.

Our R&D tax credit estimator can help you develop a preliminary estimate based on qualifying expenses and your company's research history.

The estimate is a starting point. The final credit depends on the applicable calculation method, available documentation, and the company's tax circumstances.

IRS references

This article addresses the federal R&D tax credit. State research credits may have different eligibility and expense rules.

This article is general information, not tax or legal advice. The rules are fact-specific, change over time, and depend on details unique to your company. Talk to us about how they apply to your situation.

Which Software Development Expenses Qualify for the R&D Tax Credit?