R&D Tax Credit Basics

What is the federal R&D tax credit?

The federal R&D tax credit is an incentive designed to encourage U.S. companies to invest in innovation and technological advancement. It provides a dollar-for-dollar reduction in a company’s tax liability for certain qualified research expenses (QREs). To qualify, a business must engage in research activities that meet the IRS four-part test and incur qualified research expenses.

Who qualifies for the R&D tax credit?

Companies of all sizes across a variety of industries can qualify for this tax incentive. Technically, any U.S.-based company that meets the four-part test for Qualified Research Activities and incur Qualified Research Expenses, can claim the credit.

What types of companies generally benefit from the R&D tax credit?

The federal R&D tax credit is available to companies that invest time, money, and resources in improving products and processes. While businesses in any industry can take advantage of this tax incentive, it is most commonly claimed by companies in manufacturing, engineering, software development, computer sciences, and the life sciences.

Can startups claim the R&D tax credit?

Yes. Eligible startups and small businesses may be able to apply a portion of the R&D tax credit against payroll taxes rather than income taxes. This provision can benefit early-stage companies that are investing in R&D but have not yet generated enough taxable income to fully use the credit.

Can the credit be claimed for prior years?

The R&D tax credit has a carryback period of a year and a carryforward period of 20 years. This means that any unused portions of the credit not used in the current year can be applied to prior year taxes to see if any liability can be offset. After that, any remaining credit amounts can be carried forward for a period of 20 years. If the credit is not claimed in the 20-year period, it will expire.

Qualifying Activities and Expenses

What activities qualify for the R&D tax credit?

To determine if a business qualifies for the R&D credit, the IRS requires that it meets all the requirements outlined in the four-part test. This includes:

• Permitted Purpose Test — The research must be intended to develop a new or improved product, process, software, formula, technique, or invention. Improvements may relate to function, performance, reliability, or quality.
• Technological in Nature Test — The research must rely on principles of engineering, physical science, biological science, or computer science. Activities based primarily on social sciences, arts, or humanities generally do not qualify.
• Elimination of Uncertainty Test — At the outset of the project, there must be uncertainty regarding the capability, method, or design of the business component being developed or improved.
• Process of Experimentation Test — The business must evaluate one or more alternatives to resolve the uncertainty through modeling, simulation, systematic trial and error, testing, or other methods of experimentation.

To claim the credit, a business must pass all four parts of the test and keep documentation to support all qualified research activities and expenses.

What expenses are considered qualified research expenses (QREs)?

There are two types of expenses which qualify as QRE including in-house and contract expenses. These expenses include any wages paid to any employee for qualified services, amounts paid for supplies used in the research, and amounts paid to another person for the right to use computers as part of the project.

• Wages — This includes any amount paid or incurred to an employee to provide qualified services which are defined as engaging directly in, directly supervising, or directly supporting qualified research activities. It is important to note that this does not include general administrative expenses.
• Supplies — This includes any tangible personal property like raw materials, lab chemicals and glassware, 3D printing materials, machined components, and test articles. Land or land improvements are excluded along with office supplies, computer licenses, equipment purchases, utilities, rent, insurance, travel and meals expenses. Since these expenses may be scrutinized by the IRS, it’s essential to retain receipts, invoices, documentation linking supplies to the experimentation process, and records detailing how supplies were used.
• Contract Research Expenses — This includes costs paid to a third-party to perform qualified research on the company’s behalf. Unlike other expenses which are counted at 100% these expenses are only counted at 65%. These expenses must be paid to a third party (not an employee), incurred for qualified research, performed on behalf of the taxpayer, include a written agreement for services, and be conducted within the U.S. Examples include retaining an independent software developer to build a new application, contracting with an engineering firm to test a new process, or paying a specialized lab to conduct material testing.

Calculating and Claiming the Credit

How is the R&D tax credit calculated?

There are two methods that can be used to claim the credit, and businesses typically use the method which provides the greatest tax saving benefit.

The Regular Research Credit (RRC) method is generally used by those that have a long history of research activities. The amount of the credit is generally 20% of the current year’s QREs that exceed a “base amount.”

The Alternative Simplified Credit (ASC) method is generally used by those with a limited history of research activities. The amount of the credit is 14% of the current year’s qualified research expenses that exceed 50% of the average qualified research expenses from the three immediately preceding tax years.

It’s important to note that a business is permitted to switch between calculation methods every year, if so desired.

Is documentation required to claim the R&D tax credit?

Yes. Businesses claiming the R&D tax credit should maintain documentation that supports both qualified research activities and qualified research expenses. Examples include project plans, engineering documents, testing records, technical reports, payroll records, supply invoices, contracts with third-party researchers, and other records demonstrating how the research met the IRS requirements.

What form is used to claim the R&D tax credit?

Businesses generally claim the federal R&D tax credit using IRS Form 6765. The form is used to calculate the credit and provide information about qualified research activities and expenses. The IRS recently updated Form 6765 and its instructions, increasing reporting requirements for taxpayers claiming the credit. Businesses should ensure they have sufficient documentation to support the information reported on the form.

Recent Law Changes

What changed for R&D expenses under Section 174A?

The One Big Beautiful Bill Act (OBBBA) changed how businesses deduct domestic R&D expenses. Beginning in 2025, Section 174A allows businesses to immediately deduct qualifying domestic research and experimental expenditures in the year they are incurred.

This is a change from the rules that applied between 2022 and 2024, when businesses were required to spread those deductions over five years. The new rules apply only to domestic research activities. Foreign R&D expenses must still be capitalized and amortized over 15 years, making it important to track domestic and foreign R&D costs separately.

The OBBBA also made it more important to evaluate R&D deductions and the federal R&D tax credit together. Businesses may qualify for both benefits, but coordination rules can affect the amount ultimately claimed.

What is Section 280C and why does it matter?

Section 280C contains rules that coordinate the R&D tax credit and the deduction for R&D expenses. In general, a business cannot receive a full tax credit and a full deduction on the same R&D expenses. To prevent this double benefit, taxpayers generally must either reduce certain deductions by the amount of the credit claimed or elect a reduced credit.

Although Section 280C has existed for many years, it became less of a consideration when businesses were required to spread domestic R&D deductions over five years. With the return of immediate expensing for many domestic R&D costs beginning in 2025, Section 280C once again plays a larger role in determining the overall tax benefit available. Businesses claiming both the credit and the deduction should evaluate these rules with their advisors as part of the tax planning process.

Contact the PBMares Credits & Incentives Tax Team to learn more.