Turning Innovation Costs into Opportunity

Innovation is exciting, but it’s rarely cheap. Hiring technical talent, sourcing materials, and building prototypes all take time, money, and risk. The good news? Many of these costs may qualify as Qualified Research Expenses, or QREs, making you eligible for valuable R&D tax credits. With the right approach and, more importantly, sufficient documentation, your investment in developing or improving products and processes can lead to real, measurable tax benefits.

What Counts as a Qualified Research Expense?

QREs are essentially the costs your business incurs while conducting experiments to solve technical challenges. This could mean building a new product, improving an existing process or product, or attempting to develop a new software feature. It doesn’t have to look like a lab experiment (though that certainly helps). Engineering, software development, product improvements and manufacturing activities may qualify—if they meet specific criteria.

To determine if an activity counts, the IRS uses a four-part test:

1. Permitted Purpose – The work must aim to create or improve something through technological means.
2. Elimination of Uncertainty – You must be trying to resolve at least one of three kinds of technical challenges or unknowns (a) capability – can you build or develop your design, (b) methodology – what methodology will allow you to achieve your objective, or (c) appropriate design – what design will accomplish your goal.  This is the same test for Section 174 Research & Experimental Expenditures – the code section that governs whether a taxpayer must amortize or deduct its R&D expenses.
3. Process of Experimentation – Your efforts to eliminate or solve the uncertainty(ies) must involve experimentation, which can include trial-and-error, modeling, testing, or similar approaches.
4. Technological in Nature – Your work should be grounded in the hard sciences like biology, chemistry, physics, engineering, or computer science.  Merely using a computer is not sufficient.

Key Categories of QREs

The most common and largest category of QREs is employee wages. If your team spends time designing, testing, modeling, or solving a technical issue, a portion of their compensation may qualify. Even partial time counts—as long as the amount of time and nature of the activities are documented on a project or business component basis.

For taxpayers involved with manufacturing, Supplies are another big category. Material, parts, and ingredients, used in building or testing prototypes can count. Keep those invoices, track what’s being used and why, and tie it to the project.

Many taxpayers, particularly software companies, bring in outside help—like third-party contractors, a research lab, or a specialized firm.  You may be able to include up to 65% of those costs paid to US-based contractors, even though they weren’t performed in-house.  Who gets to claim a credit depends on who is financially at risk for the success of the research and who owns the resulting IP.  Analysis of the related contract(s) is required.  Be sure to keep detailed contracts and scopes of work.

Computer rental expenses – aka hosting – is the fourth category of QREs.  If you host your software on a third-party provider like AWS, Azure or Google Cloud, the portion related to hosting software under development (pre-release), can count toward the research credit.  It’s imperative to properly allocate these expenses between production and pre-release software.  Ideally, you will be separately invoiced for the latter making it easier to calculate and support the QRE portion.

What’s Changing with the IRS and Form 6765

There are proposed changes coming to Form 6765 that could impact how R&D credits are claimed starting in the 2024 tax year. The IRS wants more detail, especially about each individual business component. This means companies may need to break out the specific QREs and explain the research conducted for each project. It may take more work up front, but it could also bring more clarity and fewer headaches if you’re ever audited.

Payroll Tax Offset Doubled for Startups

Thanks to the Inflation Reduction Act, the R&D payroll tax offset for qualifying small businesses has doubled—from $250,000 to $500,000 annually. This is especially impactful for early-stage companies that don’t yet owe income taxes. If you’re investing heavily in R&D but haven’t reached profitability, this expanded offset which is applied to your payroll taxes could significantly improve cash flow throughout the year.

How to Maximize the Credit

The R&D credit can be calculated in a couple of ways, but regardless of the method, the underlying principle is the same: better documentation leads to better results. The more clearly you can show who worked on what, the experiments conducted, how much was spent, and why it qualified, the more confident you can be in the value of your claim.

To stay ahead, consider tracking employee time at the project level, aligning finance and technical teams early, and using integrated software tools. These steps don’t just make tax time easier—they help your business stay audit-ready and unlock every eligible dollar.

Common Pitfalls to Avoid

Some businesses unintentionally leave money on the table by misclassifying expenses or under-documenting time. One common issue is lumping research and non-research labor into a single cost category, which makes it harder to isolate qualifying costs. Others forget to track improvements to existing products as separate components or overlook eligible supply and subcontractor costs. These small misses can add up.

Documentation Makes All the Difference

The IRS puts a lot of weight on documentation. You don’t need a PhD to meet their standards, but you do need consistency. Keep payroll reports, time logs, invoices, technical memos, designs of experiments, test results, meeting minutes, and project plans. If it shows your intent, process, and results, it probably supports your case.

Using a centralized tool to manage this documentation can be a game-changer. Many companies also benefit from periodic reviews or consultations with a tax advisor to ensure they’re capturing everything they should.

How Tanner Can Help

If you’re unsure what qualifies or how to organize your data, our team can help. We guide clients through everything from estimating credits and passing the four-part test to preparing Form 6765 and adapting to new requirements.

We also work with businesses across multiple platforms, including QuickBooks, Dynamics, and NetSuite, and we understand how R&D can span borders and states. Our tax team provides strategies to maximize both federal and state-level credits while helping you stay fully compliant.

The Bottom Line

If you’re putting time, talent, and capital into solving technical problems or improving how things are done, you may already be doing R&D—and leaving money on the table. With the right tools and guidance, your innovative work can turn into tax savings that fuel your next big idea. Tanner is here to help you navigate the rules, avoid the pitfalls, and claim every dollar you’ve earned through innovation. For additional information click here to contact us.