If you’ve been wasting hours tirelessly sifting through arduous tax documents, puzzling over whether your business is eligible to claim the Research and Development Tax Credits available for small to mid-sized businesses, you’ve come to the right place. To fuel growth and encourage innovation, businesses are once again able to fully deduct 100% of their domestic qualified research and experimentation expenditures. In this guide, we’ll give you a full run-down of qualifying work for the credit and how your company can maximize the credit opportunity.
Here’s even more good news: the credit is not just available for tax years moving forward. If you’re looking to recover deductions & missed credits from 2022-2024, you have until July 6, 2026 to claim them. Even if your business is not eligible for retroactive refunds, taxpayers have the option to deduct remaining unamortized R&D expenses as a larger “catch up” deduction. Choosing this option allows you to redeem costs in one year or split evenly over two tax years.
Calculating these credits can be a bit overwhelming at first, especially if you don’t know where to begin. Don’t worry–we’ll start by covering the fundamentals and build from there.
When considering qualifying activities and expenses for the research credit, the tax code provides a Four-Part Test. Qualifying activities must meet the requirements of that test. It is then the R&D tax credit qualified expenses associated with qualifying activities that are included in the credit calculation. We’ll list each part in more detail to help you understand the requirements.
Qualifying activity for the research credit must be related to developing a new or improving an existing product, process, technique, invention, formula, or software. Improvements for the research credit must be geared towards increasing function, reliability, performance, or quality.
In order for work to qualify for the research credit the taxpayer needs to establish that there were technical uncertainties around the product design, taxpayer’s capability in accomplishing the development, or the methodology that would be used. Are you asking questions like, “Can we develop it?” or “How can we develop it?” At the beginning of the work, what were the technical questions you knew you would need to answer through the development process?
Taxpayers claiming the research credit need to establish that a process of experimentation was used to resolve the uncertainty identified. Are you systematically evaluating one or more alternatives? You must demonstrate that–through the scientific method or trial and error–you are developing and testing a hypothesis, evaluating your results, refining said results, and determining where there’s been success or failure.
Your next step towards capturing credits is identifying which of your R&D expenses are actually QREs. QREs are delineated into four categories:
First, you have the broad category of wages. This is often the largest component of your QREs. A percentage of US-based, research-related Box 1 W-2 wages qualify. Note here that there is a “substantially all” rule, which allows 100% of wages to be included in QREs if the employee spent 80% or more of their time during the year on qualifying work.
The IRS will determine if your employees’ wages qualify according to the actual services performed and not solely based on their job titles or descriptions alone. This is something you should consider in your calculations if there is some ambiguity.
Qualified services, according to IRC Section 41(b)(2)(B), are identified as follows:
This means engaging in activity meeting the Four Part Test within engineering and physical, biological, and computer sciences. By this definition, the social sciences and other fields are excluded–economics, business management, behavioral sciences, arts, or humanities.
This is hands-on, first-level supervision of qualified research work. For example, a scientist who oversees lab activities but doesn’t necessarily run experiments. This qualification does NOT extend to any higher-level supervisors that this scientist would report to.
This is help offered to people conducting or directly supervising qualified research. For example, a laboratory worker cleaning equipment used in research or an individual compiling research data. This does NOT include general or administrative work that indirectly helps research activities.
Your next step is outlining which supplies were dedicated to the research process. These may be a smaller portion of your QREs. Qualifying supplies include non-depreciable, tangible personal property that is dedicated to your company’s R&D activities. These materials and tools are generally consumed or destroyed during the development process.
Something important to remember is that researchers’ licensing fees, phone bills, travel, meals, entertainment, relocation, and rental contracts are not qualified expenses. The IRS tends to be very suspicious of substantial supply QREs due to the possibility of capital and other ineligible expenses being included.
More QREs derive from US-based contract research expenditures. These amount to 65% of any expense your company paid to a non-employee (such as contractors and third parties) for qualified research purposes.
Please be aware that if you pay for research in advance, meaning for a later tax year, that cost doesn’t count right away. In other words, any pre-paid research costs don’t qualify for the research credit until the work is actually performed.
Finally, you can factor into your R&D expenses cloud computing and some software costs to the extent used in your process of experimentation. This is thanks to the IRS’ definition of in-house research expenses.
Note that there is an exclusion for internal-use software. Expenses incurred from software R&D face an additional “Three-Part High Threshold of Innovation” test that applies to any internal-use software not developed to be licensed to customers. This software is required to be:
In addition to the exclusions mentioned above regarding wages, supplies, contracts, and computing costs, there are several more you should be aware of. You won’t be able to capture costs related to:
Once all QREs have been identified, the research credit you can claim is generally 7-10% of total QREs. That may sound like small potatoes, but let’s look at an example to see how significant that figure can actually be.
Say your company spends $1,102,000 on wages, $41,145 on contract expenses, and $24,000 on supplies, bringing the total of your R&D spending to $1,167,145. The final credit amount you’ll get is $116,715, a sizable chunk of money to reinvest in your operations.
Many companies in the tech, manufacturing, and engineering sectors are benefiting from this tax credit, but so are many in other fields. To help you start compiling your own company’s QREs, take a look at some examples of what has already qualified in the past.
If your industry isn’t listed here, check out a more comprehensive list of common industry qualifying research activities here.
Having to scrutinize a long list of numbers steeped in business and legal jargon, it can be really challenging to know if you’re on the right track. Consulting with experts is highly recommended to ensure you don’t miss out on any advantages.
The IRS will examine which business components you identify as eligible for the credit. Lay them out clearly to start building your case.
Walk your potential qualified activities through the Four-Part test to see if related costs can be included. If you can’t point to how a cost supported your research, it probably doesn’t belong. If you’re in software development, don’t forget the additional Three-Part High Threshold of Innovation test if you are developing internal-use software rather than software to be licensed to customers.
This step is where things become a bit more complicated. You need to identify relevant job roles and responsibilities, track the percentage of time these employees spent on qualified activities, and use project records, interviews, or time tracking data to clearly document time allocation.
Once you have documented qualifying activities meeting the Four Part Test and have tied expenses back to that work, congratulations! You’re ready to file!
Once you’ve taken all the steps to complete your R&D study, you need to work with your tax preparer to file your form 6765 with your business income tax return. The credit can be utilized to reduce your income tax liability or in the case of some start up companies the employer’s portion of FICA. It’s essential to recognize, however, that the real value goes beyond the refund itself. The R&D tax credit can free up cash to reinvest in innovation, expand your team, or fund your next big idea. With the right processes in place, claiming the credit becomes an easily repeatable part of your tax strategy and not just a one-time win.