Do contractor costs qualify for the R&D credit?

Yes, contractor costs do qualify for the R&D credit if they meet specific IRS guidelines. Under federal rules, you can claim 65% of the amount paid to US-based contractors, provided you bear the financial risk and keep rights to the work. Offshore contractor work does not qualify for the federal credit.

The 65% rule for contractor costs

The IRS distinguishes between full-time employees and outside contractors. While you can claim up to 100% of qualified wages for your W-2 employees, contractor expenses are limited to a 65% inclusion rate.

For most startups, software development agencies and 1099 developers represent a major part of early engineering spend. Estimate your credit in the calculator.

For example, if you pay a US contractor $10,000 to build a backend API, only $6,500 of that expense counts toward your qualified research expenses. That $6,500 is then used to calculate your actual tax credit.

This means the net tax savings from a contractor bill is slightly lower than the savings from an equivalent employee salary. Even with the reduction, contractor costs remain a valuable source of tax offsets for early-stage companies.

Distinguishing contractors from employees for R&D

When compiling your R&D study, you must carefully separate your W-2 employees from 1099 contractors and agency developers. Where it fits, you must map each person to the correct category on your tax forms.

This distinction matters because the IRS applies different scrutiny to each category. Employee wages are easier to substantiate because they are tied directly to payroll tax records.

Contractor expenses require you to produce invoices, contracts, and proof of payment. If you cannot provide a clear paper trail connecting the invoices to actual development work, the IRS can disqualify the entire expense during an audit.

The US-location requirement

The federal R&D tax credit is designed to incentivize US-based innovation. Because of this, all research must be conducted inside the United States or its territories.

If you hire an offshore software development agency, none of their fees qualify for the federal credit. It does not matter if the agency is registered as a US entity or if you pay them in US dollars.

The physical location of the developer writing the code is what matters. If you use a mix of local and overseas developers, you must isolate the costs. Learn more about the R&D tax credit for agencies.

This rule also applies to remote employees and contractors who work while traveling outside the country. If a US-based contractor spends three months coding from Europe, their fees during those three months are excluded from the credit.

Keep clear records of your team's locations to avoid audit flags. The IRS pays close attention to geographic eligibility during reviews.

The financial risk test

To claim contractor costs, you must prove that your startup bears the economic risk of the development. This means you must pay the contractor even if the final software does not work or the project fails.

Treasury regulations require that if payment is contingent on the success of the research, the contractor holds the risk. In that scenario, you are paying for a finished product, not for the research itself.

To determine if you bear the economic risk, the IRS evaluates several factors:

• Payment structure. You pay the contractor for hours worked, not for a completed result.
• No performance warranty. You cannot demand free fixes if the software fails to perform as expected.
• No success contingency. You must pay the contractor regardless of whether the software is successful.

Time and materials contracts usually pass this test easily. Fixed-bid contracts where payment is tied to successful milestone delivery often do not qualify. Learn what software work qualifies as R&D.

If your contract has a warranty clause that forces the contractor to fix bugs for free, the IRS may argue you do not bear the risk. Standard software development agreements should be drafted carefully to ensure they do not accidentally disqualify your R&D claim.

The substantial rights test

The second major requirement is that your startup must retain substantial rights to the work. You do not need exclusive rights, but you must own the results of the development.

If your contract states that the agency owns the intellectual property and you are merely licensing it, you cannot claim the credit. Your master services agreement must clearly assign IP rights to your startup.

Most standard startup contractor agreements transfer all IP rights upon payment. Make sure your legal team reviews these agreements before you include the expenses in your R&D study.

Even if the developer retains a non-exclusive license to use the underlying code framework, you can still qualify. The critical factor is that you have the right to use, modify, and commercialize the specific code built for your product.

How Section G affects contractor reporting

For tax years beginning after 2025, the IRS has introduced mandatory new reporting requirements under Form 6765 Section G. Taxpayers must now itemize their qualified research expenses by specific business components.

This means you can no longer simply report a single lump sum for contractor expenses. Next, you must attribute contractor costs to specific features, products, or code releases.

This change makes detailed record-keeping critical. If you are preparing a claim, you need a system that maps contractor invoices directly to the git commits or tasks they completed.

This granular reporting is now mandatory for most startups. Preparing this manually is incredibly difficult, which is why automated tracking tools have become essential.

Tracking contractor hours and tasks

Because Section G requires project-level detail, you must back up your claims with developer history. This includes Jira tickets, GitHub commits, and Linear issues.

Claimship pulls from your actual tools to build an audit-ready study. It automatically matches contractor activity to the specific business components required by the IRS.

This automated approach saves founders from spending dozens of hours manually auditing their Slack and GitHub history. Read our detailed explanation of the R&D tax credit.