Key points covered in this article:

  • The federal R&D tax credit incentivizes U.S. companies to invest in innovation by offering a dollar-for-dollar reduction in tax liability for qualified research expenses (QREs).
  • The OBBBA restored immediate expensing for domestic R&E costs starting in 2025, allowing businesses to deduct these expenses in the year incurred, with retroactive opportunities for small businesses to amend 2022–2024 returns.
  • Companies across industries, including biological sciences, engineering, and software development, can benefit from the credit by meeting the IRS’s four-part test for qualified research activities.

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. To qualify a business, you must engage in research activity that meets the four-part test and incur qualified research expenses (QREs). There is a payroll offset for startups/small businesses and a carryforward option of up to 20 years.

Who qualifies for the R&D Tax Credit?

Companies of various sizes across a variety of industries can qualify for this lucrative 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 across several industries that have invested time, money, and resources improving products and processes. While companies in any industry can take advantage of this tax incentive, those in the biological sciences, computer sciences, engineering, manufacturing, and software development companies generally qualify.

What activities qualify for the R&D credit?

To determine if a business qualifies for the R&D credit, the IRS requires that it meets all the requirements outlined in the “4 part test”. This includes,

  • Section 174 Test – To pass this test, it is required that all expenses must be incurred with the business and represent R&D costs. If a company is trying to develop a new product or process, it is esoteric. In some cases, it is easier to say what doesn’t qualify when reviewing the list. Quality control that’s not research and development: consumer surveys, advertising, none of that qualifies. Acquiring a patent from someone else that doesn’t qualify. And then, interestingly, soft sciences don’t qualify, it must be hard science like engineering, chemistry, computers, physics and biology.
  • Discovering Technological Information Test – To pass this section, the process of experimentation must be used to discover information that fundamentally relies on the principles of physical, biological, engineering, or the computer sciences. A taxpayer must employ existing technologies and rely on principles of the sciences mentioned above.
  • Business Component Test – To pass this section, the information discovered must be used to develop a new or improved business component. This is defined as any product, process, software, technique, formula, or invention, which is to be held for sale, lease, license, or used in the company’s business. It is essential that the taxpayer be able to tie research for which it is claiming the credit to a relevant business component.
  • Process of Experimentation – To pass this section, the business must demonstrate the process of experimentation is designed to evaluate one or more alternatives to achieve an outcome where the result is the capability or method of achieving a result, is uncertain at the beginning of research activities. In addition to the requirement the research is undertaken for the purpose of discovering information that is technological in nature, they must also:
    • Identify the Uncertainty – This must be accomplished to demonstrate the development or improvements of a business component that is the object of research activities.
    • Identify Alternatives – These must be intended to eliminate the uncertainty.
    • Identify and Conduct of Process of Evaluation – This applies to the evaluation of all alternatives.

There are certain exclusions to these requirements which apply in specific circumstances. Finally, it is important to note that to be considered eligible the business must pass all four parts of the test.

How is the credit calculated?

There are two methods which can be used to claim the credit including the Regular Research Credit (RRC) method and the Alternative Simplified Credit (ASC) method. Businesses typically use the method which provides the greatest tax saving benefit. While the details are complex, the 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 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 is important to note, a business is permitted to switch between calculation methods every year if so desired.

Finally, businesses claiming the credit under Section 174 are now required to capitalize and amortize expenses rather than immediately deducting them.

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 support qualified research activities. Engaging in qualified research means conducting specific research activities. Direct supervision means the immediate supervision of qualified research (a scientist that directly supervises experiments but does not perform them). Finally, direct support means support of people engaging in, or directly supervising research activities. It is important to note that this does not include general administrative expenses.
  • Supplies – This includes any tangible personal property (something you can touch) except for land or land improvements. Examples include raw materials, lab chemicals and glassware, 3D printing materials, machined components, and test articles. Items such as office supplies, computer licenses, equipment purchases, utilities, rent, insurance, travel and meals expenses are excluded. 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.

Is documentation required?

Yes, to claim the credit a business must retain documentation that substantiates the expenses claimed are eligible for the credit. This should include:

  • General information: chart of accounts, organization charts
  • Accounting method: Are costs accumulated by department or by project?
  • Activities: What are they, and why are they eligible for the R&E credit?
  • Wages: Names, amounts, % of annual wages, departments, job titles & descriptions
  • Supplies: Categories, how they tie in to general ledger, amounts by category
  • Contracts: With whom, amounts, categories, and how the services rendered tie back into the R&D process.

Additional information should be retained to help identify the appropriation of company resources or details of research projects conducted throughout the year, including:

  • Materials explaining research activities, including brochures, pamphlets, press releases, and other similar documents.
  • Submissions to management, the board of directors, review committees or other similar groups regarding research projects, activities, expenditures, and the research credit.
  • Documents prepared by, or on behalf of, internal audit, including quarterly and annual reports that refer in any manner to research activities.
  • Minutes, notes, or other similar recordings from budget, board of directors, managerial or other similar meetings concerning research activities.
  • Project authorizations, budgets, or work orders that initiates a research project.
  • The internal authorization policies for approving a research project.
  • Project summaries and/or progress reports and project meeting minutes.
  • Field and lab verification data/summary data.
  • Research credit studies conducted by outside consultants.
  • Papers, treatises, or other published documents regarding the taxpayer’s research.
  • Complete copies of contracts (including all modifications), letter agreements, memoranda of understanding, or similar documents for research performed by, or on behalf of, a third party

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.

How did the OBBBA change the R&D Tax Credit?

The One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025, significantly altered the treatment of research and development expenses and their relationship to the R&D tax credit. Most importantly, it restored the ability for businesses to immediately deduct domestic research and experimental expenditures under a new Section 174A, reversing the Tax Cuts and Jobs Act’s requirement that such costs be amortized over five years. Taxpayers now have the option either to expense these costs in the year incurred or to elect amortization over a minimum of 60 months. For costs that were already capitalized between 2022 and 2024, the Act provides transition relief by allowing taxpayers to accelerate the deduction of the remaining unamortized amounts in 2025, or to spread them evenly over 2025 and 2026. Eligible small businesses, defined as those with average gross receipts under $31 million, can retroactively apply full expensing for 2022 through 2024 by filing amended returns.

The changes also reinstated the long-standing Section 280C(c) rule that requires coordination between deductions and the R&D tax credit. Before the TCJA, taxpayers claiming the full gross research credit were required to reduce their deductible R&D expenses by the credit amount or alternatively elect a reduced credit in order to preserve their full deduction. The TCJA’s capitalization rules had disrupted that framework, but the OBBBA has reintroduced it starting with tax years beginning after December 31, 2024. This means that businesses now must once again decide between reducing their deductions or accepting a reduced credit. The Act further amends Section 41 by clarifying that qualified research expenses are treated as Section 174A expenditures, ensuring that the credit aligns with the new expense regime. For small businesses amending prior returns, the retroactive application of expense also requires retroactive application of Section 280C(c), meaning the research credit they claimed in those years may effectively be reduced by around 21 percent unless they elect the reduced credit option.

Overall, the OBBBA simplified cash flow planning by restoring immediate expense, created flexibility in how past capitalized costs can be handled, and reinstated the pre-TCJA coordination rules that tie deductions and credits together. While this creates opportunities for businesses to accelerate tax benefits, it also reintroduces a complex trade-off between the value of deductions and the value of the R&D tax credit, requiring careful planning to optimize results under the new framework.

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