IRS Rules for R&D Expenses and Tax Credits

Research and development (R&D) expenses represent a company’s investment in discovering new information and creating new or improved products, processes, or software. The Internal Revenue Service (IRS) provides a mandatory framework for how businesses must account for these costs. These rules determine how costs are reported and impact a company’s tax liability over several years. The tax code also offers incentives, such as tax credits, designed to encourage domestic research activities.

Identifying Qualifying R&D Activities and Costs

For an activity to be considered qualified research by the IRS, it must satisfy a four-part test. The first element is the permitted purpose test, which requires the research to be undertaken to create a new or improved business component in terms of its function, performance, reliability, or quality. For instance, a software company developing a new algorithm to increase data processing speed would meet this requirement. The goal must be a tangible improvement, not just a cosmetic change.

The second part of the test is that the research must be technological in nature. This means the process of experimentation must rely on principles of the physical or biological sciences, engineering, or computer science. A food manufacturer experimenting with new chemical formulations to extend a product’s shelf life is an example of applying principles of science. This requirement ensures that the research is grounded in a scientific discipline.

A process of experimentation is the third condition. This involves an evaluation of one or more alternatives to eliminate uncertainty about the development or improvement of a business component. This could include systematic trial and error, developing and testing hypotheses, or modeling and simulation to evaluate different approaches.

The final element is the elimination of uncertainty test. At the outset of the project, the business must be uncertain about the capability or method for developing or improving the business component, or the component’s appropriate design. For example, an aerospace company may be uncertain if a new, lighter composite material can withstand the stresses of flight.

Once an activity qualifies, certain associated costs are eligible for specific tax treatment. These include wages paid to employees for performing, supervising, or directly supporting qualified research. The cost of supplies used during the research process, such as materials for building a prototype, also qualifies. Additionally, 65% of the amounts paid to third parties for contract research are included, which can increase to 75% for payments to certain qualified research institutions.

Certain activities are explicitly excluded from the definition of qualified research, including:

• Market research, advertising, and promotional expenses
• Quality control testing of finished products
• Efficiency surveys and management studies
• Research conducted after commercial production has begun
• Adaptation of an existing business component for a particular customer

Mandatory Capitalization and Amortization of R&D Expenses

A significant change in tax law, effective for tax years beginning after December 31, 2021, altered how businesses must treat their R&D expenses. Under Internal Revenue Code (IRC) Section 174, companies are no longer permitted to deduct these expenses in the year they are incurred. Instead, they must capitalize these costs and amortize them over a predetermined period.

The amortization period for these capitalized costs depends on where the research activities take place. For research conducted within the United States, the period is five years. If the research is performed outside the United States, a 15-year amortization period applies. This distinction creates a tax incentive for businesses to locate their R&D operations domestically. Amortization begins at the midpoint of the tax year in which the expenses are incurred, a rule known as the mid-year convention.

For example, a company that incurs $100,000 in domestic R&D expenses during a tax year would have a first-year deduction of $10,000 ($100,000 / 5 years 0.5). For each of the next four years, the company would deduct $20,000 per year. In the sixth year, the final $10,000 would be deducted, completing the amortization.

The rules under Section 174 also address situations where a research project is abandoned. Even if a project is deemed a failure, the business cannot immediately write off the remaining unamortized costs. The company must continue to amortize the capitalized expenses over the remainder of the original 5-year or 15-year period.

Claiming the Research and Development Tax Credit

Separate from expense rules, the tax code provides an incentive known as the Credit for Increasing Research Activities, governed by IRC Section 41. This is a tax credit, which reduces a company’s tax liability on a dollar-for-dollar basis, rather than a deduction, which reduces taxable income. Businesses can claim this credit even while capitalizing and amortizing the same expenses under Section 174.

The expenses that qualify for the credit are known as Qualified Research Expenses (QREs). QREs include in-house research expenses (wages and supplies) and contract research expenses. These are similar to the costs capitalized under Section 174, but QREs also include amounts paid for the use of computers in conducting qualified research. For contract research, 65% of the expense paid to a third party qualifies as a QRE.

There are two primary methods for calculating the R&D tax credit: the Regular Credit (RC) method and the Alternative Simplified Credit (ASC) method. The RC method involves a calculation of a base amount derived from the company’s historical R&D spending and gross receipts. The credit is equal to 20% of the QREs that exceed this base amount.

The ASC method is often preferred for its simplicity. Under this method, the credit is 14% of the QREs for the current year that exceed 50% of the average QREs for the three preceding tax years. This calculation does not require the extensive historical gross receipts data needed for the RC method, making it more accessible for many businesses. A business must elect to use the ASC on its tax return.

For most taxpayers, the R&D tax credit is non-refundable, meaning it can only be used to reduce income tax liability to zero. However, certain qualified small businesses may elect to use a portion of the credit, up to $500,000 annually, to offset their payroll tax liability. This can provide a cash flow benefit even if the business has no income tax liability.

Required Documentation and Forms

To claim R&D deductions and credits, businesses must maintain thorough and contemporaneous documentation. This documentation substantiates the research activities in an IRS examination and should be created as the work occurs. Documents to maintain include:

• Project plans
• Technical specifications
• Design documents
• Detailed notes from meetings where technical challenges were discussed

Businesses must keep payroll records that identify employees who worked on qualified research projects and the time they dedicated to those tasks. Invoices and proof of payment for supplies must be retained. All contracts and invoices related to third-party contract research should also be kept, clearly outlining the scope of work and costs.

The primary form for claiming the R&D tax credit is Form 6765, Credit for Increasing Research Activities. It requires the taxpayer to report the total QREs for the year, broken down into categories like wages, supplies, and contract research. Recent updates to Form 6765 require more detailed reporting on the business components and projects that generate the QREs.

The mandatory amortization of R&D expenses is reported on Form 4562, Depreciation and Amortization. This is the standard form used by businesses to claim deductions for the depreciation of assets and the amortization of various capitalized costs. A separate section on this form is used to report the total capitalized R&D costs and to calculate the allowable amortization deduction.

Submitting R&D Claims with Your Tax Return

The final step is to submit the R&D claims with the annual income tax return. The specific primary return depends on the business structure. For a C corporation, the forms are attached to Form 1120, the U.S. Corporation Income Tax Return. S corporations will attach Form 6765 and Form 4562 to their Form 1120-S, while partnerships will attach them to Form 1065.

The calculated amortization deduction from Form 4562 will flow to the appropriate line on the main tax return, reducing the business’s taxable income. The R&D credit calculated on Form 6765 is reported in the credits section of the primary tax return, directly reducing the tax owed for the year. It is important to ensure all attachments are included and the figures from the R&D forms are correctly transferred to the main return to avoid processing delays or notices from the IRS.