What Expenses Qualify for R&D Tax Credit?

The Research and Development (R&D) tax credit is a federal incentive designed to encourage businesses to invest in innovation and technological advancement within the United States. It provides a dollar-for-dollar reduction in income tax liability for qualified research activities, offering a direct financial benefit to companies that develop or improve products, processes, formulas, or software. This credit helps businesses offset staffing and supply costs associated with research programs, allowing them to reinvest in future growth and maintain competitiveness.

Defining Qualified Research

Activities must meet specific criteria to be considered qualified research for the R&D tax credit. The IRS outlines a “four-part test” that all activities must satisfy.

The first part, known as “Permitted Purpose,” requires that the research aims to create or improve the function, performance, reliability, or quality of a new or existing business component. A business component can be a product, process, software, technique, formula, or invention. The improvement does not need to be groundbreaking for the entire industry, only new or improved for the company itself.

Next, the research must demonstrate an “Elimination of Uncertainty.” This means the activity must resolve technical uncertainty concerning the development or improvement of a product or process. This criterion focuses on the unknown aspects of a project, such as capability, design, or methodology.

The third criterion is a “Process of Experimentation.” The research must involve a systematic process of experimentation to achieve the desired result. This includes evaluating alternatives through testing, modeling, simulation, or trial and error.

Finally, the activity must be “Technological in Nature.” This means the research must rely on principles of physical or biological sciences, engineering, or computer science. This ensures the research involves a scientific approach, not social science or marketing studies.

Categories of Qualified Research Expenses

Qualified Research Expenses (QREs) are the costs businesses can include when calculating the R&D credit. These expenses primarily fall into three main categories: wages, supplies, and contract research.

Wages

Wages paid for qualified services performed by employees directly engaged in, directly supervising, or directly supporting qualified research activities are eligible. Qualified services involve the actual conduct of research, such as lab experiments, supervision, or fabricating experimental models. Wages are defined as all taxable wages reported on Form W-2, including bonuses and stock option redemptions. Non-taxable income or certain fringe benefits are not included.

Only the portion of wages directly attributable to qualified research activities can be claimed, not an employee’s entire salary if they perform other duties. If “substantially all” (at least 80%) of an employee’s time is spent on qualified services, then 100% of their wages can be included as a QRE. If less than 80% of their time is spent on qualified activities, only the actual hours dedicated to those services qualify. For example, an engineer spending 85% of their time developing a new production process would have 100% of their salary considered for the credit.

Direct support for research does not include general and administrative services, or other services that only indirectly benefit research activities. Clerical support or general administrative personnel, even if part of the research department, do not qualify if their services are only indirectly beneficial to the research. Careful tracking of employee time and activities is important.

Supplies

Supplies are defined as tangible property used or consumed in the conduct of qualified research. This excludes land, improvements to land, and property subject to depreciation, such as equipment. Qualifying supplies include chemicals, raw materials, components for prototypes, and small- or large-scale test batches.

Materials used or scrapped during process development, custom equipment, or tooling specifically for research purposes also qualify. Laboratory supplies, machined and electrical components, and 3D printing filament used to resolve technical uncertainty are considered qualified supplies. General overhead supplies like office supplies, utilities, or rental fees are not eligible unless directly consumed in the research process itself.

It is possible to include materials as qualified supplies even if they are later sold, provided the original intent was to resolve technical uncertainty during the research. For product improvements, only the materials for the new or improved subcomponents qualify.

Contract Research Expenses

Amounts paid or incurred to another person (not an employee of the taxpayer) for qualified research performed on behalf of the taxpayer can be included as contract research expenses. Generally, only 65% of these expenses are eligible for the credit.

For contract research to qualify, the taxpayer must bear the economic risk of the research and retain substantial rights to the research results. If payment is contingent on research success, it may be considered a payment for a product or result rather than for the performance of research, and thus not a qualified expense. General consulting services that do not involve qualified research or where the taxpayer does not retain rights do not qualify.

A higher percentage, 75%, applies to amounts paid for basic research performed by universities or federal laboratories. Basic research is fundamental experimental or theoretical work to acquire new knowledge of phenomena and facts, without any particular application or use in view.

Non-Qualifying Expenses

Understanding which expenses do not qualify for the R&D tax credit is important. Certain activities and expenditures are excluded, even if they seem related to innovation.

Research conducted outside the United States, Puerto Rico, or any U.S. possession is not eligible for the R&D tax credit. Only domestically performed research qualifies for the U.S. federal credit.

Research in the social sciences, arts, or humanities is excluded. The R&D tax credit specifically targets activities rooted in physical or biological sciences, engineering, or computer science. Market research, consumer surveys, or management/efficiency studies do not qualify.

Research funded by another person or entity, such as through a contract or grant, is not eligible to the extent it is funded by that third party. The taxpayer must bear the economic risk and retain substantial rights to the research for it to qualify.

Routine data collection, quality control, or routine testing activities are excluded. These activities are performed to verify a product works as intended rather than to resolve technical uncertainty or improve a business component. Similarly, efficiency surveys, management studies, or efforts solely aimed at adapting or duplicating existing business components without significant innovation do not qualify. Exclusively cosmetic changes to a product’s appearance are excluded unless achieving the cosmetic effect requires technological advances.

Costs for internal-use software may be excluded unless it meets higher thresholds: innovative, significant economic risk, and not commercially available. Expenses incurred after commercial production begins are not eligible.

Documentation and Claiming the Credit

Record-keeping is important for substantiating R&D tax credit claims. Businesses must retain detailed records to support eligible expenditures.

Key records include project documentation (lab notes, design specifications, test results, meeting minutes detailing research progress). Time tracking for R&D employees is important, demonstrating hours spent on qualified services. This includes W-2 forms, payroll registers, and detailed time logs.

Invoices and contracts for supplies and contract research expenses verify costs. General ledger reports indicating related business expenses and supplies are important. Internal memos, communications, and patent applications can further support the claim. The IRS requires documentation of business components, research activities, and total qualified wage, supply, and contract expenses.

The R&D tax credit is claimed on federal income tax returns using IRS Form 6765, “Credit for Increasing Research Activities.” This form is submitted with the taxpayer’s original corporate income tax return. Eligible small businesses can use the credit to offset income tax liability, and certain startups can offset up to $250,000 per year against payroll tax liability. Businesses meeting criteria (less than $5 million in current year gross receipts and no gross receipts for any tax year preceding the five-year period ending with the credit year) may utilize the payroll tax offset. The credit can be carried forward for up to 20 years if current year tax liability is insufficient. Businesses can claim the R&D credit retroactively by filing amended returns for open tax years (up to three years).