Ready to invest in innovation within your business? If so, you could be eligible for a powerful incentive: the federal research and development (R&D) tax credit. The R&D tax credit is available to businesses that create or improve products, processes, software, or technologies.
Understanding the R&D tax credit can empower your business to offset the costs of innovation and reinvest them into business growth.
Whether you’re a startup or an established business, this guide will walk you through everything you need to know about the tax credit.
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What is the R&D tax credit?
The federal research and development (R&D) tax credit is a dollar-for-dollar credit available to businesses that incur expenses during qualified research.
“Qualified research” is research done to discover information that is technological in nature for the use of developing a new or improved business component. All research activities must relate to a new or improved function, performance, reliability, or quality.
According to the IRS, the business component includes any of the following that your business will hold for sale, lease, license, or use:
- Product
- Process
- Computer software
- Technique
- Formula
- Invention
The R&D tax credit is a government incentive encouraging businesses to invest in innovation. Introduced in 1981, the tax credit supports economic growth through technological advancement.
The tax credit isn’t just available for tech businesses or laboratories—it can apply to a range of industries. With the R&D tax credit, you can lower your tax bill by the exact amount of the tax credit. You might be able to claim a tax credit against your payroll taxes.
| Did You Know? |
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| In addition to the federal R&D tax credit, most states (e.g., Arizona, California, Ohio, Pennsylvania, etc.) also offer an R&D tax credit. |
Payroll tax credit election for qualifying small businesses
Not all businesses owe federal income tax yet, but small businesses in their early stages can still benefit from the R&D tax credit.
Qualifying small businesses can claim a payroll tax research credit and apply it against a payroll tax liability (e.g., FICA tax) of up to $500,000.
Qualifying small businesses are those with:
- Gross receipts under $5 million in the tax year
- No gross receipts for any tax year before the five-tax-year period ending with the tax year
Who can claim the R&D tax credit?
Many business owners think the R&D tax credit is only available to large corporations or labs. In reality, any business developing or improving a product, process, technique, formula, or software might qualify.
Your research must meet the IRS’s four-part test to qualify for the R&D tax credit:
- Section 174 test: The activity must attempt to eliminate uncertainty of the development or improvement of a product.
- Discovering technological information test: Your research activity should rely on principles of physical or biological sciences, engineering, or computer science.
- Business component test: The activity must aim to create or improve a product, process, software, invention, or technique that your business holds for sale, lease, license, or use.
- Process of experimentation test: The work must involve a process of experimentation (e.g., evaluating one or more alternatives).
Businesses that might commonly claim the R&D tax credit include software development, food production, manufacturing, life sciences, engineering, and architecture companies.
Excluded research activities
The research and development tax credit doesn’t apply to all research activities. The IRS does not allow the credit for:
- Research done after starting commercial production
- Duplicating existing products or processes
- Research that adapts an existing product or process to a particular customer’s needs
- Research that relates to certain internal-use computer software
- Surveys or studies
- Research that someone else is funding
You must conduct all research in the United States or a U.S. territory (e.g., Puerto Rico) to claim the credit.
What expenses can you claim?
The R&D tax credit is calculated based on Qualified Research Expenses (QREs). These include the following categories:
Wages: You can claim the tax credit on the total wages for all qualified services for all business components. Don’t include wages that you use to claim the work opportunity credit.
Supplies: You can claim the tax credit on the cost of supplies used for all business components.
Rental or lease cost of computers: You can claim expenses you paid or incurred for the rental or lease of computers in qualified research. The computers must be located off your premises, and you cannot be the operator or primary user of the computers.
Contract research: You can include 100% of amounts you paid or incurred for qualified energy research that an eligible small business, a university, or a federal laboratory performed. Include 75% of amounts you paid or incurred by a qualified research consortium, and include 65% of amounts paid or incurred for all other qualified research by any other person.
Basic research payments: Include 100% of the qualifying payments you made to an eligible small business, a university, or a federal laboratory. Include 75% of payments to a qualified research consortium, and include 65% of payments paid or incurred for all other qualified research by any other person.
How to calculate the credit
There are two main methods to calculate the R&D tax credit:
- Regular credit method: The regular credit method is more complex than the alternative simplified credit method, but the maximum credit rate—20%—is higher.
- Alternative simplified credit (ASC) method: This is a simpler way to claim the credit than the regular credit method, but the maximum credit rate—14% (or 6^ if no prior QREs)—is less than the regular credit method. Many businesses choose this method.
How to claim the research and development tax credit
File Form 6765, Credit for Increasing Research Activities, to claim the R&D tax credit.
You’ll need to have accurate and up-to-date records to back up your claim, such as project descriptions, qualifying wages, and supply records.
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