R&D Tax Credit Explained: How to Qualify and Claim Your Business Incentives

R&D tax credits are a significant part of tax planning for any industry that qualifies for it.

It provides substantial financial relief to businesses investing in innovation. This credit reduces tax liability on qualifying research activities, allowing companies to reinvest in new product development and advance technology. 

For businesses aiming to stay competitive and lead in their sectors, the R&D Tax Credit serves as a powerful tool to help offset the high costs associated with groundbreaking projects.

What is the R&D Tax Credit?

The Research and Development (R&D) Tax Credit is a federal incentive that encourages domestic innovation. It provides a dollar-for-dollar reduction in federal tax liability for qualifying activities, including product design, process improvement, and software development. This benefit supports diverse industries, from manufacturing and life sciences to software and agriculture, helping them manage the high costs often tied to innovation.

Background 

The R&D Tax Credit was first enacted in 1981 as a temporary provision under Section 41 of the Internal Revenue Code (IRC), a response by Congress to a perceived decline in domestic investment in research activities. At the time, there was growing concern that U.S. companies were under-investing in R&D, putting the nation at a competitive disadvantage on the global stage. This initial version of the credit offered companies an incremental credit, rewarding them based on increases in their R&D spending over a baseline amount.

Since its inception, the credit has evolved through various legislative changes to address different economic needs. One significant enhancement was the PATH Act of 2015 (Protecting Americans from Tax Hikes Act), which made the R&D Tax Credit a permanent provision of the U.S. tax code. This change provided companies with the stability needed to plan long-term R&D investments, as they could now reliably include the credit in their tax strategy. 

Additionally, subsequent amendments, including those introduced by the Tax Cuts and Jobs Act of 2017 (TCJA), have further defined the credit, impacting areas like amortization requirements for R&D costs.

Eligibility Criteria

The R&D Tax Credit is available to businesses of all sizes and across various industries, provided they engage in qualifying research activities. Generally, any company that undertakes efforts to develop or improve products, processes, software, techniques, formulas, or inventions may qualify for this credit. This accessibility was significantly expanded by the PATH Act of 2015, which allowed more small-to-medium-sized businesses and startups to benefit from the credit.

Four-Part Test for Qualifying Research Activities

To qualify for the R&D Tax Credit, the IRS requires that all R&D activities meet the four-part test set out in Section 41 of the Internal Revenue Code. Each component of this test is important in determining whether an activity qualifies as eligible R&D.

1. Permitted Purpose

The research activity must be related to developing or improving the functionality, quality, reliability, or performance of a business component. A “business component” is broadly defined and includes any product, process, software, technique, formula, or invention. The permitted purpose criterion is met if the goal of the activity is to create something new or improve something that exists, adding value to the business.

2. Technological in Nature

The activity must rely on principles of a hard science, such as engineering, physics, chemistry, computer science, or biology. This criterion ensures that eligible activities are rooted in scientific or technical research rather than, for example, market research or social sciences. The activity does not need to push the boundaries of the field itself but must use scientific methods or principles.

3. Elimination of Uncertainty

To qualify, the activity must be intended to eliminate uncertainty related to the development or improvement of a business component. Uncertainty exists when the information needed to achieve the desired result is unknown at the outset, and the research is conducted to determine if the desired goal can be accomplished or how best to accomplish it. This requirement underscores that qualifying activities involve a degree of technical risk or challenge.

4. Process of Experimentation

The qualifying R&D activities must involve a systematic process of experimentation. This means that the business must evaluate one or more alternatives to achieve the desired result, often through a process of trial and error. Experimentation could involve modeling, simulation, testing, or iterative design to resolve uncertainties. The process of experimentation must be systematic, although it doesn’t need to follow a specific method, as long as it is demonstrably rigorous and structured.

Qualifying Activities and Expenses

The R&D Tax Credit applies to a range of activities that demonstrate genuine innovation or improvement in business components. Qualifying activities and associated expenses can be categorized to help businesses assess which of their R&D efforts may be eligible for the credit.

Qualifying Activities

To claim the R&D Tax Credit, businesses must engage in activities that aim to develop or improve products, processes, software, techniques, formulas, or inventions. 

Below are examples of activities that typically qualify:

• Product Development: Efforts to create new products or significantly enhance the functionality, quality, or reliability of existing products.
• Process Improvement: Innovations in manufacturing or operational processes designed to improve efficiency, reliability, or performance.
• Software Development: Development of software or applications that require a degree of technical innovation or problem-solving, often found in fields like software engineering and data processing.
• Formulas and Techniques: Research focused on developing new or improved formulas (e.g., in the chemical or food industries) or techniques that add value or improve a business component’s utility.
• Inventions and Prototypes: The creation and testing of prototypes, pilot models, or inventions to determine feasibility or enhance functionality.

Eligible Expenses

In addition to qualifying activities, certain expenses incurred in the course of R&D are eligible for the tax credit. Understanding which costs can be included in credit calculations is key to accurately capturing the full benefit. Commonly eligible expenses include:

• Wages: The wages or salaries paid to employees directly involved in qualifying R&D activities are a significant expense category. This includes researchers, engineers, software developers, and other technical staff engaged in R&D efforts. Wages for employees who directly supervise or support R&D activities can also qualify.
• Supplies: Costs for materials and supplies used in the development or improvement of a product, process, or other qualifying component. This may include items used in prototype development or testing but excludes capital expenses, such as large equipment or facilities.
• Contract Research: Payments made to outside contractors for research services can also qualify for the credit, provided the research is performed within the United States and meets eligibility requirements. Businesses can include 65% of these costs in the calculation.
• Cloud Computing and Hosting Fees: Expenses related to cloud computing resources directly used in R&D activities, such as software development or data-intensive research, may be eligible, depending on usage and documentation.

Non-Qualifying Activities

While the R&D Tax Credit supports a wide range of innovative efforts, certain activities are explicitly excluded from eligibility. These non-qualifying activities typically involve routine tasks, adaptation of existing products, or activities beyond the scope of technical research. 

Research After Commercial Production

Once a product or process enters commercial production, any further research or modification is no longer eligible for the R&D Tax Credit. This includes any changes made to improve production efficiency or to scale the product. The credit applies strictly to efforts made during the research and development phase, before a component reaches a stable, commercially viable state.

Adaptation of Existing Products

Activities that adapt or customize an existing product, process, or software to suit a particular customer’s needs, rather than advancing the underlying technology or functionality, do not qualify for the credit. This includes customization or modification of existing products to meet specific customer specifications, as it does not advance the product or process itself.

Market Research and Testing

Market research, consumer testing, and quality assurance activities are also excluded from qualifying for the R&D Tax Credit. These activities focus on assessing market demand, gathering customer feedback, or ensuring product quality rather than engaging in scientific or technical experimentation. Similarly, promotional and advertising costs fall outside of R&D eligibility.

Foreign Research (Limitations Apply)

While certain contract research expenses qualify, foreign research generally does not, as the R&D Tax Credit is intended to stimulate domestic innovation. To be eligible, research must be performed within the United States or U.S. territories. Limited exceptions may apply under specific contractual and regulatory circumstances, but as a rule, foreign research activities are excluded from the credit calculation.

How to Claim the R&D Tax Credit

Claiming the R&D Tax Credit involves a structured process, including completing IRS Form 6765, which is specifically designed for Credit for Increasing Research Activities. Proper documentation and accurate calculations are essential for ensuring compliance and maximizing the credit’s value.

Step-by-Step Guide to Filling Out IRS Form 6765

1. Gather Documentation: Before beginning, collect all records of qualified expenses (e.g., wages, supplies, contract research) and any documentation supporting your R&D activities.
2. Complete Section A or Section B:some text
   • Section A: Use this to claim the Regular Credit, following the traditional method of calculating the credit based on a fixed base percentage and gross receipts.
   • Section B: Choose this section to claim the Alternative Simplified Credit (ASC), which simplifies the calculation by basing it on recent R&D expenditures without needing historical data.
3. Identify and Complete Additional Sections as Required:some text
   • Section C: List any additional forms or schedules required based on your business’s structure, which may impact how the credit is calculated or reported.
   • Section D: For qualified small businesses (QSBs) electing to use the credit against payroll tax, this section allows you to specify this election, especially helpful for startups with limited income tax liability.
4. Calculate the Credit Amount: Businesses are advised to calculate the credit under both the Regular and ASC methods, choosing the option that yields the greatest tax benefit.
5. Submit with Tax Return: Attach the completed Form 6765 to your company’s tax return. Be sure to keep copies of all supporting documents.

Documentation and Record-Keeping Requirements

Proper documentation is required for substantiating the R&D Tax Credit claim. Required records may include financial statements, payroll records, and detailed project notes. Documentation should capture:

• Technical Project Details: Project descriptions, objectives, and technical uncertainties faced.
• Employee Timesheets: Detailed tracking of hours spent by employees on R&D activities.
• Receipts and Invoices: Proof of eligible expenses, such as materials used in R&D or fees for external research contractors.
• Experimentation Logs: Documentation of the processes, models, and alternatives tested.

Having this documentation in order helps verify qualifying expenses and activity compliance, reducing the risk of disallowance during IRS audits.

Options for Calculating the Credit

There are two primary methods to calculate the R&D Tax Credit, allowing businesses to choose the one that provides the largest benefit.

1. Regular Credit: The Regular Credit calculation considers historical spending and involves a fixed-base percentage based on past R&D activities. It generally requires consistent R&D spending over multiple years, making it beneficial for companies with steady or increasing R&D investments over time.
2. Alternative Simplified Credit (ASC): The ASC is a simpler option that calculates the credit based on current and recent R&D expenditures. Companies opting for ASC do not need historical data beyond the prior three years, making it ideal for newer businesses or those without extensive R&D records.

Additional Forms Based on Business Structure

Certain business structures may require additional forms or schedules to claim the credit:

• Partnerships and S Corporations: Must complete additional schedules to pass the credit through to partners or shareholders.
• Qualified Small Businesses (QSBs): Eligible startups with gross receipts under $5 million can elect to apply the R&D Tax Credit against up to $250,000 in payroll taxes. These companies can utilize Section D of Form 6765 to specify this election, especially useful for startups with limited or no federal income tax liability.
• Payroll Tax Offset for QSBs: Qualified Small Businesses (QSBs) can elect to apply the R&D Tax Credit against their payroll tax liability. Eligible QSBs can offset up to $250,000 annually for up to five years. This election is made on Section D of Form 6765 and allows startups to reduce payroll taxes, freeing up cash flow to reinvest in growth activities.

Recent Legislative Changes Impacting the R&D Tax Credit

Legislative changes over recent years have significantly shaped the R&D Tax Credit, impacting how businesses can claim and benefit from it. Key laws include the Tax Cuts and Jobs Act (TCJA) and the Protecting Americans from Tax Hikes (PATH) Act, each introducing specific provisions and implications for R&D expenditures.

Impact of the TCJA on R&D Expense Amortization

The Tax Cuts and Jobs Act (TCJA) of 2017 introduced a significant change to R&D expense treatment starting in 2022. Under the TCJA, businesses are no longer allowed to deduct R&D expenses in the year they’re incurred. Instead, companies must amortize these expenses over five years for domestic research or 15 years for foreign research, starting from the midpoint of the taxable year in which the expense was incurred. This shift in amortization requirements has impacted cash flow for businesses heavily invested in R&D, as they now face a delay in fully realizing the tax benefits of these expenses.

Changes Brought by the PATH Act

The PATH Act of 2015 made the R&D Tax Credit a permanent feature of the U.S. tax code under Section 41, which provided long-term certainty for businesses investing in R&D. The PATH Act also expanded the credit’s applicability by allowing eligible small businesses to apply the R&D credit against alternative minimum tax (AMT) and payroll tax liabilities. This extension opened the credit to more small-to-medium-sized companies, especially startups, helping them benefit from R&D tax incentives even if they lacked federal income tax liabilities.

Future Considerations and Potential Legislative Updates

Future legislative changes may address amortization requirements established by the TCJA, as some lawmakers and industry advocates push to reinstate immediate deductibility of R&D expenses to ease cash flow constraints on innovative businesses. Additionally, there is ongoing discussion around expanding or modifying the R&D Tax Credit to align with evolving technology and industry needs. Companies should stay informed about potential updates, as any changes could further enhance the credit’s benefits or introduce new compliance requirements.

Eligible Industries for R&D Tax Credit

The R&D Tax Credit is accessible across a broad range of industries, providing financial incentives for businesses engaging in innovative research and development activities. While nearly any company involved in qualifying R&D efforts may be eligible, certain industries commonly benefit due to the nature of their operations.

Manufacturing

The manufacturing industry frequently qualifies for the R&D Tax Credit due to ongoing efforts to improve products, processes, and production efficiencies. This includes developing new manufacturing techniques, enhancing product quality, and implementing advanced automation solutions, all of which require technical research and experimentation.

Software Development

Software development companies often engage in activities that qualify for the R&D Tax Credit, such as creating new applications, enhancing software performance, and developing complex algorithms. The credit applies not only to traditional software companies but also to businesses in other sectors that develop proprietary software for internal use or customer-facing solutions.

Biotechnology

The biotechnology industry benefits extensively from the R&D Tax Credit due to its focus on developing innovative products like new pharmaceuticals, medical devices, and diagnostic technologies. Activities in biotech typically involve high levels of research and experimentation, from lab-based testing to clinical trials, making this industry a prime candidate for the credit.

Engineering

Engineering firms working on projects that require advanced technical solutions or novel design approaches are also eligible. This can include civil, mechanical, electrical, and structural engineering projects where companies invest in developing new designs, materials, and methods to address unique project challenges or improve existing technologies.

Agriculture

In the agriculture industry, businesses can claim the R&D Tax Credit for research aimed at improving crop yields, developing new farming techniques, or creating more sustainable and resilient agricultural practices. Companies involved in developing bioengineered crops, improving soil health, or experimenting with agricultural technology often qualify for the credit.

Food and Beverage

The food and beverage industry benefits from the R&D Tax Credit through activities focused on product development and improvement, such as creating new recipes, enhancing food preservation methods, or developing innovative packaging solutions. Companies in this sector also qualify when they conduct research to meet regulatory standards or to achieve better product consistency and quality.

Common Challenges and Misconceptions

Despite the substantial benefits of the R&D Tax Credit, businesses often face challenges and misconceptions that may prevent them from claiming it or realizing its full value.

Misconceptions About Eligibility

Several misconceptions persist around who qualifies for the R&D Tax Credit:

• Only Large Companies Qualify: Many small-to-medium-sized businesses believe the credit is reserved for large corporations with extensive R&D budgets. However, the credit is accessible to companies of all sizes, including startups and smaller firms.
• Only Successful Projects Are Eligible: Some companies mistakenly think that only successful R&D projects qualify. In reality, the credit applies to all qualifying research activities, regardless of outcome, allowing companies to claim expenses even if a project doesn’t yield the desired result.
• The Credit Isn’t Worth the Effort: There’s a perception that claiming the R&D Tax Credit is overly complex and offers limited value. However, the financial benefits often outweigh the effort, especially with proper guidance and documentation.

Navigating Complex Tax Regulations

Complex tax regulations around R&D activities can be a barrier. Understanding IRS requirements and differentiating between qualifying and non-qualifying activities can be challenging, especially without dedicated tax expertise. You can use a tax research tool to navigate complex tax regulations efficiently. It will help you save your valuable time.

Maintaining Adequate Documentation

Detailed documentation helps substantiate R&D Tax Credit claims, yet it’s often challenging for businesses to maintain. Keeping thorough records of R&D projects and associated costs is crucial, as insufficient documentation may lead to disallowed credits in the event of an audit.

Staying Current with Legislative Changes

Evolving tax laws, such as the recent amortization requirements for R&D expenses, introduce complexity and affect how companies can claim the credit. Staying informed on legislative updates helps businesses maximize the credit and avoid compliance issues, but it’s a challenge for many companies without dedicated tax resources.

Final Thoughts

The R&D Tax Credit is a valuable incentive that encourages innovation by providing significant financial benefits to businesses investing in research and development. Companies of all sizes should consider exploring their eligibility to take advantage of this credit, which can reduce tax liabilities and support growth. 

FAQs

What expenses qualify for the R&D Tax Credit?

Qualifying expenses include wages paid to employees engaged in R&D, costs of supplies used in experimentation, and contract research expenses for R&D performed by third parties in the U.S. Certain cloud computing costs related to R&D activities may also qualify.

Can startups claim the R&D Tax Credit?

Yes, startups can benefit from the R&D Tax Credit. Qualified Small Businesses (QSBs) with less than $5 million in gross receipts and within their first five years can apply the credit against payroll taxes, providing cash flow benefits even if they have little to no income tax liability.

How has the TCJA affected R&D deductions?

The Tax Cuts and Jobs Act (TCJA) introduced a requirement to amortize R&D expenses over five years for U.S.-based research (15 years for foreign research), beginning in 2022. This change limits the ability to immediately deduct R&D expenses, impacting cash flow for some companies.

What is the difference between the Regular Credit and the Alternative Simplified Credit?

The Regular Credit calculation uses a fixed base percentage and considers historical R&D spending, while the Alternative Simplified Credit (ASC) is calculated based on recent R&D expenditures without the need for extensive historical data. Businesses are advised to calculate both and choose the option offering the greater benefit.

How long can unused R&D credits be carried forward?

Unused R&D Tax Credits can generally be carried forward for up to 20 years, allowing companies to apply the credit in future years when they have tax liabilities. This flexibility makes the credit valuable over the long term, even if it can’t be fully used immediately.

How much is the R&D tax credit worth?

The R&D Tax Credit is typically worth 6% to 8% of qualified annual R&D expenses. The exact amount depends on the method used for calculation (Regular Credit or Alternative Simplified Credit) and the company’s qualifying research expenses.

What activities qualify for the R&D credit?

Activities aimed at developing or improving products, processes, software, techniques, or formulas typically qualify, as long as they meet the IRS’s four-part test (purpose, technological nature, uncertainty elimination, and experimentation process).

Can small businesses claim the R&D credit?

Yes, small businesses can claim the R&D Tax Credit. Eligible small businesses (QSBs) can even apply the credit against payroll taxes, making it accessible for startups with limited or no income tax liability.

What is the 25/25 limitation?

The 25/25 limitation refers to a cap on the R&D credit for C corporations with over $25,000 in regular tax liability. These corporations cannot offset more than 75% of their tax liability by utilizing the R&D credit.

How much R&D expenses can be claimed?

There is no specific cap on the total qualified R&D expenses a business can utilize when calculating the R&D credit amount. However, limitations apply based on tax liability and the chosen calculation method, so companies should carefully calculate to maximize their credit.