Introduction

When people hear “research and development,” they may think of scientists in a laboratory or a large technology company inventing something new. However, in regard to the federal Research and Development Tax Credit, usually called the R&D Tax Credit, it may apply to many everyday businesses.

A manufacturer testing a better production method, a software company developing a new feature, an engineering firm comparing designs, or a food company testing a new formula may all be performing work that could qualify.

A business does not need a laboratory, a patent, or a successful final product. What matters is what the business was trying to improve, what technical problem it faced, and how it tested possible solutions.

What Is the R&D Tax Credit?

The R&D Tax Credit is a federal tax credit officially called the Credit for Increasing Research Activities. It is calculated on IRS Form 6765.

A tax credit is different from a tax deduction. A deduction lowers the income that is taxed. A credit directly lowers the tax owed.

For example, a $10,000 deduction only reduces taxable income by $10,000. A $10,000 tax credit, subject to applicable limits, may reduce the actual tax bill by $10,000.

The credit is normally used against federal income tax & only certain eligible small businesses can use part of it against employer payroll taxes instead.

How Can You Qualify?

Businesses in many industries may qualify for this credit. However, the work itself must meet federal requirements.

The IRS generally reviews each product, process, software program, technique, formula, or invention separately. Each one is known as a “business component.” The work on that component must generally pass a four-part test.

1. The business was trying to create or improve something

The work must be intended to create or improve the function, performance, reliability, or quality of a product, process, software program, formula, technique, or invention. In everyday language, the business must be trying to make something work, work better, or become more dependable. Changes made only for appearance, style, or routine maintenance generally do not qualify.

2. There was technical uncertainty

At the start of the project, the business must have been unsure about an important technical question. For instance, it may have been unknown whether the idea would work, how to build it, which design would work best, or which method would produce the desired result. The business does not have to prove that nobody in the world knew the answer. It generally needs to show that the answer was not already clear to that business.

3. The work relied on science or engineering

The project must rely on principles from physical science, biological science, engineering, or computer science. Employees do not all need science or engineering degrees. The problem and the work used to solve it simply must be of a technical nature.

4. The business tested possible solutions

The business must evaluate one or more alternatives. This is called a process of experimentation. Testing may include building prototypes, running simulations, trying different materials, comparing designs, changing software code, conducting trials, or using systematic trial and error. The project does not have to succeed. A failed prototype or abandoned design may still support the credit if the business conducted qualifying research.

What Activities May Qualify?

Potential qualifying activities may include:

• Developing or improving products
• Creating or improving software
• Designing and testing prototypes
• Testing different materials or formulas
• Improving manufacturing methods
• Reducing waste while maintaining quality
• Solving technical problems involving performance, reliability, or safety

An example of this is when a manufacturer tests machine settings to reduce defects, while a software company may compare system designs to improve speed.

Routine quality checks, market research, employee training, ordinary repairs, management studies, and copying an existing product generally do not qualify. Research conducted after commercial production begins may also be excluded.

Research performed outside the United States or a U.S. territory generally does not qualify. Research in the social sciences, arts, or humanities is also excluded.

Internal-use software, such as software developed mainly for accounting, human resources, or administrative functions, must meet additional requirements.

Which Costs Can Be Included?

The credit is based on qualified research expenses, often shortened to QREs. The main categories are employee wages, supplies, certain computer costs, and contract research.

Employee wages may qualify when employees perform the research, directly supervise it, or directly support it. General office work and high-level management oversight usually do not count unless the person is directly involved.

Supplies may qualify when used directly in the research, such as materials used to build and test prototypes. Land, buildings, depreciable equipment, and general overhead are not qualifying supplies.

Certain costs for renting or leasing computers used in qualified research may also count when the requirements are met.

When an outside contractor performs qualified research, 65 percent of the eligible payment is generally included. The agreement generally must be in place before work begins, the research must be performed for the business, and the business must bear the cost even if the research fails.

How Much Is the Credit Worth?

There is no single percentage that applies to every business. The amount depends on current research expenses, prior-year expenses, gross receipts, the calculation method selected, and other tax rules.

Under the regular method, the credit is generally 20 percent of qualified research expenses above a calculated base amount. The base amount is based partly on the company’s research history and gross receipts, so this method can become complicated.

Many businesses use the Alternative Simplified Credit, or ASC. Under this method, the preliminary credit is generally 14 percent of current-year QREs that exceed 50 percent of the average QREs from the previous three tax years.

Suppose a business has $300,000 of QREs this year and its average QREs for the previous three years were $200,000.

Half of $200,000 is $100,000. Subtracting that from $300,000 leaves $200,000. Fourteen percent of $200,000 is $28,000.

That is a preliminary credit of $28,000.

If the business makes the Section 280C reduced-credit election, the current Form 6765 instructions generally reduce that amount to 79 percent, or $22,120. Other limits may affect how much that can be used that year.

The reduced-credit election allows the business to take a smaller credit without making a separate reduction to its related research expense deduction. A tax professional can compare the available options and determine which treatment is more beneficial.

Can a Startup Use the Credit Against Payroll Taxes?

Some startups and newer businesses may not owe enough federal income tax to use the credit. A qualified small business may instead apply up to $500,000 of the credit against certain employer payroll taxes.

To qualify for this option, the business generally must:

• Have less than $5 million in gross receipts for the credit year
• Have no gross receipts before the five-tax-year period ending with the credit year

The credit is first applied against the employer’s share of Social Security tax, subject to the applicable limit. Any remaining credit is then applied against the employer’s share of Medicare tax. If the business cannot use the entire credit during one payroll quarter, the unused amount generally carries forward to a later quarter.

The business must make the election on Form 6765 attached to a timely filed original income tax return. It then uses Form 8974 with its payroll tax return.

The payroll tax election generally cannot first be made on an amended return. It is also generally limited to five tax years.

This option can be especially helpful for a startup that is spending money on development but has not yet become profitable.

What Records Should a Business Keep?

Good documentation is essential. A business should be able to explain:

• What it was developing or improving
• What technical uncertainty existed
• Which possible solutions it considered
• What tests or experiments it performed
• Which employees or contractors performed the work
• How the qualifying expenses were calculated

Helpful records may include project notes, design files, test results, source code records, prototype records, employee time information, payroll reports, invoices, contracts, and statements of work.

Job titles alone are not enough. For example, the wages of an employee with the title “engineer” do not automatically qualify. The business must consider what the employee actually did and how much time was spent on qualifying activities.

For tax years beginning after 2025, many taxpayers must report business-component information in Section G of Form 6765. Certain smaller businesses filing an original return may be exempt.

One exemption may apply when total QREs are no more than $1.5 million and average annual gross receipts for the prior three years are no more than $50 million. Other conditions also apply. Even when Section G is not required, records should connect the claimed expenses to qualifying projects.

The Credit and the Research Expense Deduction Are Different

The R&D Tax Credit is separate from the tax deduction for research expenses.

For tax years beginning after December 31, 2024, domestic research and experimental expenses are generally deductible in the year paid or incurred. A business may instead choose to spread those domestic expenses over at least 60 months.

Foreign research expenses generally cannot be deducted immediately and must instead be spread over 15 years.

Claiming the R&D Tax Credit may require the business to reduce its related research expense deduction unless it makes the reduced-credit election. This interaction is another reason the calculation should be reviewed by a qualified tax professional.

Could Your Business Qualify?

Many businesses perform qualifying research without calling it R&D where they may describe the work as product development, process improvement, engineering, testing, software development, or problem solving.

The best way to evaluate a possible claim is to review specific projects, identify the technical uncertainties involved, determine how possible solutions were tested, connect the work to eligible expenses, and maintain clear records.

The R&D Tax Credit can provide a meaningful tax benefit, but it is not automatic. A strong claim is based on qualifying work, a careful calculation, and documentation showing what the business did and why it meets the rules.

Because each business and project is different, companies should speak with a qualified tax professional before claiming the credit. If you would like to make sure you qualify and get the most out of your credits, reach out to Volpe Consulting!