The Research and Development (R&D) Tax Credit, formally known as the Credit for Increasing Research Activities, is a federal tax incentive designed to reward companies for investing in innovation.

If your business develops or improves products, software, processes, formulas, or technologies, you may qualify for a dollar-for-dollar reduction of federal taxes. The credit is calculated on IRS Form 6765 and filed with your annual tax return.

Despite the name, the R&D credit is not limited to labs, scientists, or white coats. Many companies claim it every year without realizing their work qualifies.

How the R&D Credit Works

The R&D tax credit reduces your tax liability based on Qualified Research Expenses (QREs) incurred during the year.

For profitable companies, the credit typically offsets income taxes owed.
For early-stage companies, Congress created a way to access the credit even before profitability.

Payroll Tax Offset for Small Businesses

If your business:

• Is less than five years old, and

• Has under $5 million in gross receipts,

you may be able to use the R&D credit to offset payroll taxes instead of income taxes. This provides real cash benefit today, not later.

Unused R&D credits can also be carried forward for up to 20 years and applied when taxes are due in the future.

What Counts as R&D for Tax Purposes?

The tax definition of research is much broader than most people expect.

For R&D credit purposes, research generally means:

• Using a trial-and-error process

• To eliminate technical uncertainty

• In the development or improvement of a product, process, software, formula, or invention

The research must be conducted within the United States, including Puerto Rico and Guam.

If that sounds complex, it is. It took the federal government more than 20 years to finalize the rules.

The Four-Part R&D Test

To qualify, activities must meet all four parts of the R&D test under the Internal Revenue Code.

1. Uncertainty Test

The activity must seek to eliminate uncertainty related to:

• Capability

• Method

• Appropriate design

The goal must be to discover information that resolves that uncertainty.

2. Technological in Nature Test

The research must rely on principles of:

• Engineering

• Computer science

• Physical sciences

• Biological sciences

3. New or Improved Business Component Test

The research must relate to developing or improving a:

• Product

• Process

• Software

• Technique

• Formula

• Invention

4. Process of Experimentation Test

At least 80 percent of the activities must involve a process of experimentation, meaning systematic trial and error, modeling, simulation, or testing alternatives.

What Costs Qualify for the R&D Credit?

Qualified Research Expenses generally fall into four categories.

1. Wages paid to employees for time spent on:

   • Direct research activities

   • Supervising research

   • Supporting research

   Note: Only the portion of time related to qualified research is included.

2. Supplies Costs used in research, including:

   • Raw materials

   • Utilities

   • Prototype materials

   • Pilot models used for testing

3. Contract Research - Generally, 65 percent of payments to third parties for qualified research performed on your behalf.

4. Computer Usage - Amounts paid for the right to use computers in the conduct of qualified research.

How Much Is the R&D Credit Worth?

The value of the credit depends on your facts, history, and calculation method. There are two primary federal calculation methods.

Method 1: Regular Credit Method

• Gross credit equals 20 percent of qualified expenses above a base amount

• For many companies, this equates to roughly 10 percent of QREs

• Net benefit is often around 8 percent, depending on tax rate

Method 2: Alternative Simplified Credit (ASC)

• Gross credit equals 14 percent of current year QREs minus 50 percent of the prior three-year average

• If spending is consistent, this typically equals about 7 percent

• First-year filers often receive around 6 percent

State R&D Credits

Many states offer their own R&D credits. Rules and rates vary widely.

• States like California and Utah offer credits comparable to the federal program

• Other states offer smaller incentives

When federal and state credits are combined, total net benefits often average around 12 percent of qualified research costs.

Why the R&D Credit Is Often Missed

Most missed R&D credits are not caused by a lack of innovation. They are caused by:

• Incomplete analysis

• Overreliance on prior-year assumptions

• Manual, spreadsheet-based studies

• Misinterpretation of the qualification rules

Understanding the rules is the first step. Applying them correctly is where most providers fall short.

Not Sure If You Qualify? Let’s Find Out.

Most companies that qualify never claim the full credit. Not because they lack innovation, but because the analysis stops short.

We can help you determine whether you qualify and how much credit you may be leaving on the table.

Talk to an expert