Many business owners assume R&D tax credits are only for pharmaceutical companies or tech giants with massive research labs. That assumption costs them thousands in missed tax savings every year.
The reality? If your business develops new products, improves processes, or solves technical problems, you likely qualify for the Research and Development Tax Credit under IRC Section 41.
The Four-Part Test
The IRS uses a four-part test to determine if your activities qualify. Your work must meet all four criteria:
- Permitted Purpose - Your research must aim to create a new or improved product, process, software, technique, formula, or invention.
- Technological in Nature - The work must rely on principles of engineering, computer science, biological science, or physical science.
- Elimination of Uncertainty - You must be attempting to eliminate uncertainty about the capability, method, or design of the business component.
- Process of Experimentation - You must evaluate alternatives through modeling, simulation, systematic trial and error, or other methods.
You don't need to succeed. Failed experiments still count as qualified research.
Qualifying Expenses
Three categories of expenses can be claimed:
- Wages - Payments to employees for qualified services performed during research activities. This includes the time employees spend directly conducting research, supervising research, and supporting research activities.
- Supplies - Tangible property used and consumed in research. This excludes land, improvements to land, and depreciable property.
- Contract Research - 65% of amounts paid to outside contractors for qualified research performed on your behalf.
What Does NOT Qualify
The IRS explicitly excludes certain activities:
- Research conducted after commercial production begins
- Adapting existing products for a specific customer
- Reverse engineering from physical examination
- Routine quality control testing
- Efficiency surveys and data collection
- Research funded by grants or contracts
- Research conducted outside the United States
2025 Legislative Updates
The One Big Beautiful Bill Act (OBBBA), signed July 4, 2025, reinstated immediate expensing for domestic R&E expenditures. This reverses the TCJA requirement to capitalize and amortize these costs over 60 months. This change is permanent and applies retroactively.
New detailed reporting requirements under Form 6765 Section G are optional for tax year 2025. Beginning in 2026, Section G becomes mandatory for most filers. Exceptions apply for qualified small businesses electing the payroll tax credit, and taxpayers with total QREs under $1.5 million AND gross receipts under $50 million.
Qualified small businesses can now apply up to $500,000 of the R&D credit against payroll tax liability instead of income tax. This is particularly valuable for startups and businesses without current tax liability.
Calculating the Credit
Most businesses use the Alternative Simplified Credit (ASC) method:
Formula: 14% × (Current Year QREs − 50% of Average QREs for Prior 3 Years)
Example:
- Current year QREs: $500,000
- Average of prior 3 years: $400,000
- Base amount: $200,000 (50% of $400,000)
- Credit: $42,000 (14% of $300,000)
Documentation Requirements
The IRS has increased scrutiny on R&D claims. Proper documentation is essential. Maintain these records:
- Project descriptions with technical objectives
- Time tracking for employees on research activities
- Supply receipts with allocation methodology
- Contractor agreements and detailed invoices
- Documentation of technical uncertainty
- Records of experimentation process and results
- Meeting notes and project communications
Document research activities contemporaneously. Reconstructing records after the fact weakens your claim.
Industries That Often Overlook R&D Credits
Many businesses conduct qualifying research without realizing it:
- Manufacturing - Process improvements, new product development, tooling design, quality improvements
- Construction - New building techniques, material testing, design engineering, structural innovations
- Food and Beverage - Recipe development, packaging innovation, shelf-life testing, production process improvements
- Software Development - New features, architecture improvements, performance optimization, integration development
- Agriculture - Crop yield optimization, equipment modifications, irrigation systems, pest management solutions
- Aerospace and Defense - Component design, testing protocols, systems integration, material science
Common Mistakes to Avoid
- Claiming too little - Many businesses underestimate their qualifying activities. A thorough analysis often uncovers more than expected.
- Poor documentation - The IRS can disallow credits if you cannot substantiate your claims with contemporaneous records.
- Missing the payroll tax election - Qualified small businesses should evaluate whether the payroll tax credit provides greater benefit.
- Overlooking contract research - Third-party research often qualifies, even when conducted by vendors or consultants.
Next Steps
If your business spends money solving technical problems or improving products, you should evaluate your R&D credit eligibility. A proper analysis examines your operations, identifies qualifying activities, and calculates the potential credit. For most businesses, the analysis pays for itself many times over.
