How to Apply for R&D Tax Credits for Your Business

Reducing tax liability through R&D tax credits can free up capital for businesses investing in innovation. Many companies overlook this opportunity, assuming they don’t qualify or that the process is too complex. However, with proper guidance, securing these credits can be straightforward and financially beneficial.

Understanding what expenses qualify and how to document them is essential for a successful claim.

Qualifying Research Criteria

To claim R&D tax credits, businesses must ensure their activities meet IRS requirements. The Four-Part Test determines eligibility by evaluating technological uncertainty, experimentation, reliance on hard sciences, and a qualified purpose.

Technological uncertainty exists when a company is unsure whether it can develop or improve a product or process due to limitations in existing knowledge. This could involve challenges in achieving a specific performance level, integrating new materials, or refining manufacturing techniques. If an expert in the field cannot readily determine the outcome, the work likely qualifies.

The process of experimentation requires systematically testing different approaches to resolve uncertainty. This includes modeling, simulation, prototyping, or trial-and-error testing. The IRS expects companies to document their iterative process, showing how they evaluated alternatives and refined their approach.

For an activity to qualify, it must rely on principles of physical or biological sciences, engineering, or computer science. Research grounded in economics, social sciences, or aesthetic design does not meet this standard. For example, developing a financial model would not qualify, but creating an algorithm to improve data processing efficiency could.

The research must aim to develop or improve a product, process, software, technique, or formula that benefits the company’s trade or business. Routine quality control, reverse engineering, and adapting existing products for specific customers do not qualify. The focus must be on innovation that enhances functionality, performance, reliability, or cost efficiency.

Types of Qualified Costs

Businesses can claim R&D tax credits for expenses directly related to research activities. The IRS allows deductions for costs necessary for developing or improving products, processes, or software. These expenses generally fall into five categories: supplies, testing, wages, contracted services, and software development.

Supplies

Supplies include tangible materials used in research that are not capital assets, such as raw materials, prototype components, and laboratory consumables. For example, a company developing a medical device may claim the cost of plastic, metal, and electronic components used in prototypes.

Only materials directly used in experimentation qualify. General office supplies and equipment purchases like computers or lab machinery do not count, as they are depreciable assets. However, materials consumed during testing, such as chemicals in a pharmaceutical trial, can be included.

To substantiate supply costs, businesses should maintain invoices, purchase orders, and usage logs to ensure expenses can be traced directly to R&D activities.

Testing

Testing costs cover expenses incurred while evaluating prototypes, processes, or software to determine feasibility or performance. This includes laboratory testing, field trials, and quality assurance procedures that are part of the research process. For example, an aerospace company developing a new aircraft component may conduct wind tunnel tests to assess aerodynamics.

Routine quality control checks and regulatory compliance inspections do not qualify. For instance, a food manufacturer testing products for FDA labeling requirements would not be eligible, but experimenting with new preservation techniques to extend shelf life could be.

Businesses should document testing procedures, results, and modifications made based on findings. Keeping records of test reports, lab notes, and data analysis helps demonstrate that the expenses were necessary for resolving technological uncertainty.

Wages

Employee wages are one of the most significant expenses eligible for R&D tax credits. Businesses can claim a portion of salaries paid to employees directly involved in research activities, including engineers, scientists, software developers, and other technical staff engaged in designing, testing, or improving products and processes.

Only wages for employees performing qualified research, supervising research efforts, or directly supporting research activities can be included. For example, a mechanical engineer designing a new energy-efficient motor qualifies, but an HR manager overseeing hiring for the R&D department does not. The percentage of time an employee spends on research determines the portion of their wages that can be claimed.

To substantiate wage claims, businesses should maintain time-tracking records, project documentation, and payroll reports. The IRS may require evidence showing how much time employees spent on qualifying activities. Using project management software or detailed timesheets can help ensure compliance.

Contracted Services

Businesses often hire outside firms or consultants to assist with research projects. Payments to third parties for qualified research services can be included in the R&D tax credit calculation, but only 65% of the contract amount is eligible.

To qualify, the contracted work must meet the same Four-Part Test applied to internal research. For example, if a company hires a software development firm to create a new algorithm, the cost may be eligible. However, if the contract is for routine IT support or system maintenance, it would not qualify.

Contracts should clearly define the scope of work, specifying that the services involve experimentation and technological development. Businesses should retain invoices, agreements, and progress reports to substantiate claims.

Software Development

Software development costs can qualify for R&D tax credits if they involve creating new or improved functionality, performance, or reliability. This includes developing proprietary software, enhancing existing applications, or designing innovative algorithms. For example, a fintech company building a machine-learning model to detect fraudulent transactions may be eligible.

Routine maintenance, bug fixes, and minor updates do not meet IRS criteria. Additionally, software developed for internal use must demonstrate significant innovation and not be commercially available.

Businesses should document development efforts, including coding logs, design specifications, and testing results. Maintaining records of development sprints, version control history, and technical challenges faced can help substantiate claims.

Calculating the Credit

Determining the R&D tax credit amount requires applying one of two calculation methods: the Regular Research Credit (RRC) or the Alternative Simplified Credit (ASC).

The RRC allows businesses to claim up to 20% of qualified research expenses (QREs) exceeding a base amount. This base is calculated using a fixed percentage of the company’s gross receipts from a designated historical period, typically 1984–1988 for long-established firms. If a company did not exist during those years, an alternative base percentage is determined based on the first few years of research expenditures. While the RRC can result in a larger credit, it requires maintaining detailed financial records from prior years, which can be a challenge for newer businesses or those without consistent R&D spending.

The ASC, introduced in 2006, provides a credit of 14% of QREs that exceed 50% of the company’s average research expenses from the prior three years. If no research expenditures were incurred in those years, the business can still claim a credit equal to 6% of its current-year QREs. This method eliminates the need for extensive historical data and is often preferred by startups or companies with fluctuating R&D spending.

Once calculated, the credit can offset federal income tax liability. For eligible small businesses—those with less than $50 million in gross receipts—the credit can also offset the Alternative Minimum Tax. Additionally, startups with less than $5 million in gross receipts may apply up to $250,000 of the credit against payroll taxes. Any unused credit can typically be carried forward for up to 20 years.

Filing Requirements

Claiming the R&D tax credit requires submitting IRS Form 6765, Credit for Increasing Research Activities, alongside the company’s federal tax return. This form details qualified research expenses, the chosen calculation method, and any applicable payroll tax election for eligible startups.

Pass-through entities, such as S corporations and partnerships, do not claim the credit at the entity level. Instead, the benefit flows through to shareholders or partners, who report their respective portions on their personal tax returns. Individual taxpayers must consider passive activity limitations under IRC Section 469, which may restrict their ability to use the credit against personal tax liabilities.

State-level R&D tax credits may also be available, with many jurisdictions offering their own incentives. Some states follow the federal framework, while others impose additional restrictions or alternative calculation methods. For example, California’s R&D credit uses a fixed-base percentage model distinct from the federal ASC, and Texas provides a sales tax exemption for certain R&D expenditures instead of a direct credit.

Documentation Essentials

Proper documentation is necessary to substantiate an R&D tax credit claim. Businesses should maintain detailed records that clearly link qualified expenses to specific research activities.

Project documentation should include technical reports, design schematics, test results, and development logs. Meeting minutes, emails, and internal communications can help establish the timeline and objectives of R&D efforts. Financial records, such as payroll reports, invoices, and general ledger entries, should clearly reflect research-related costs.

In the event of an IRS audit, businesses must present documentation that aligns with the Four-Part Test and supports the claimed expenses. Using project management software or maintaining structured records can simplify this process. Engaging a tax professional with experience in R&D credits can help ensure compliance and maximize the benefit.