Research & Development (R&D) Tax Credit FAQs

Known as the Research and Development (R&D) tax credit, it is a federal incentive that allows eligible companies to reduce federal income tax liability by investing in activities that develop or improve products, processes, software, or technologies. At its core, the credit is designed to keep high-paying development jobs in the U.S. by rewarding companies that are developing or improving new or improved business components by resolving technical problems, innovating, or improving how things are made or delivered. It applies across a wide range of industries, including manufacturing, construction, software development, engineering, consumer products, life sciences, and even certain activities in agriculture.

The credit is governed by Internal Revenue Code Section 41 and is calculated based on a company’s qualified research expenses (QREs) over a minimum threshold. These expenses typically include wages for employees directly involved in R&D, the cost of supplies used in testing or prototyping, computer rental, and a portion of contractor costs related to qualified research activities. To determine eligibility a company must satisfy the four-part test. This includes proving the research is designed to create a new or improve an existing business component, is technological in nature, involves technical uncertainty, and uses a systematic process of experimentation to resolve that uncertainty.

Many companies pursue the credit because it can be a valuable tax saving tool. It offers a dollar-for-dollar reduction in federal taxes owned, rather just a deduction. What’s more is that it can be carried forward for up to 20 years, allowing for additional savings in the future. Eligible small businesses may apply the credit against payroll rather than income taxes.

The federal R&D Tax Credit plays a significant role in encouraging domestic innovation, helping businesses offset the cost of development efforts while improving competitiveness and cash flow.

To qualify for the credit, a company must show that the project (or business component) meets all requirements necessary to constitute qualified research, which is determined through a four-part test, all components of which must be met. Activities that satisfy this test constitute “qualified research.”

1. Section 174 Test – Eligible R&D credit expenses must be of the type that are treated as domestic research or experimental expenditures under Section 174A.  This means the expenditure must be incurred in connection with a company’s trade or business and represent a cost in the experimental or laboratory sense. Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. Whether expenditures qualify as research or experimental expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents. The ultimate success, failure, sale, or use of the product is irrelevant to determining eligibility under section 174A.
2. Technological Information Test – To pass this test, the R&D activity must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science.  The mere use of a computer in performing the research is not enough.
3. Business Component Test—The business must apply the information discovered through the R&D activity to enhance an existing or develop a new business component. A business component is any product, process, technique, invention, or formula that is to be held for sale, lease, license, or used in the taxpayer’s business. A taxpayer must be able to tie the research to a relevant business component.
4. Process of Experimentation Test – To pass this test, a company must demonstrate that substantially all of the research activities (at least 80%) constitute elements of a process of experimentation. To the extent that the research activities don’t meet the experimentation threshold as the business component level, the company can apply the test at the next largest sub-level. A process of experimentation is defined as a process that evaluates one or more alternatives to achieve a result where the capability of achieving the result is uncertain as of the beginning of the project.  Recent court decisions have equated this to following the scientific method.

Qualified Research Expenses are the specific categories of costs that businesses can include when calculating the federal R&D tax credit under Internal Revenue Code Section 41. These expenses must be directly tied to activities that meet the IRS four-part test for qualified research. QREs are limited to four categories.

• Qualified wages are defined as W-2 box 1 taxable compensation paid to employees directly performing, supervising, or directly supporting qualified research.  Other compensation subject to social security taxes, such as guaranteed payments to a partner, may be treated as eligible wages. The term “direct supervision” means the immediate supervision (first-line management) of qualified research (as in the case of a research scientist who directly supervises laboratory experiments, but who may not actually perform experiments). The term “direct support” means services in the direct support of either persons engaging in the actual conduct of qualified research, or persons who are directly supervising those engaging in the actual conduct of qualified research.
• Qualified supplies are tangible materials used in or consumed in qualified research. This includes during experimentation, such as prototype materials, testing components, or trial production inputs. The IRS points out that travel, meals, entertainment, telephone expenses of researchers, relocation or rental/lease expenses, general utility expenses, and royalty or license expenses are not eligible.
• Computer Rental. Qualified computer rental are amounts paid to rent or lease computers, servers, and related hardware used directly in the conduct of qualified research activities. The costs must relate to the taxpayer’s own research efforts and generally cover time‑based or usage‑based rental fees allocable to qualified activities. Such payments constitute computer rental only if the computers are (a) owned by an unrelated third party, (b) located off the company’s premises, and (c) the company is not the primary user of the computer. Examples include compute charges for cloud hosting for staging or testing, or AI model training .
• Contract Research. Qualified contract research is payments to third-parties performing qualified research on behalf of the company. Generally, only 65% of these costs can be included as QREs, and the taxpayer must retain rights to the research and bear the financial risk for the work. In addition, costs associated with research conducted outside the U.S. and activities incurred after commercial production has begun are excluded.

While taxpayers are not required to submit documentation when claiming the R&D Credit with their annual tax return, they are, however, required to maintain records that substantiate the qualified activities and the associated costs. Proper documentation is essential in the event the IRS conducts a review and is one of the most common areas where clams fail. There are two types of documentation (i) technical to prove the work qualifies, and (ii) financial records to prove the QREs are accurate and properly calculated.

• Technical Documentation. These records are used to demonstrate the qualified research meets the four-part test. Examples include design documents, engineering notes, technical specifications, project plans, and meeting notes that reflect decision-making and problem-solving. There should also be testing records such as prototypes, simulation test results, and QA reports which are needed to demonstrate a trial-and-error process took place. Overall, the documentation should be clearly tied to the business component in development and identify the nature of the work being performed and by whom it is performed. Finally, it’s important to save emails and internal communications to establish timelines.
• Financial Documentation. These records are commonly used to substantiate QREs. Examples include payroll records that tie employee wages to R&D activities, such as employee time tracking reports and job costing systems. For supplies, invoices and purchase records must show that materials were used in the R&D process (e.g., prototypes or testing materials, not capital equipment). For contract research, contracts, agreements and invoices should support the nature of the work performed under contracts, ownership of resulting IP, and who is financially at risk for the related expenses.

Since the IRS has increased scrutiny on R&D claims, including more detailed disclosures on amended returns, it’s important to collect comprehensive documentation. It should be well organized, contemporaneous and specific to each tax year. Unfortunately, those relying only on estimates or lack a clear connection between activities and expenses are at a higher risk of disallowance.

A wide range of companies qualify for the R&D Credit because eligibility is based on the nature of activities performed rather than industry. However, there are industries that generally generate significant qualifying activities due to the level of uncertainty and experimentation involved in standard business activities.

• Manufacturing. This is one of the most active sectors for R&D credits, as companies frequently work to improve production processes, enhance product durability, reduce waste, or develop new product lines. Activities such as prototyping, tooling design, automation improvements, and materials testing often meet the four-part test.
• Software and Technology. These companies are also strong candidates, particularly those engaged in developing new applications, building integrations, improving system performance, or creating scalable architectures. Even internal-use software can qualify if it meets heightened criteria around innovation and technical risk.
• Engineering and Architecture. These businesses regularly qualify when designing systems, structures, or components that require technical analysis, modeling, and iterative problem-solving. This includes civil, mechanical, electrical, and environmental engineering work. The challenge for this group is showing what development is at financial risk or not funded by a third party.
• Life Sciences. These companies frequently qualify due to work involving product development, testing, and regulatory-driven innovation. This includes development or improvement of therapeutics and medical devices, process improvements in labs, and certain clinical or technical advancements.
• Agriculture and Agribusiness. These operations can qualify when they are improving crop yields, irrigation systems, equipment efficiency, or developing new growing techniques, particularly when experimentation and data-driven decision-making are involved.