Businesses should be interested in the R&D Tax Credit because it provides a direct dollar-for-dollar reduction in federal tax liability, and in many cases, state tax liability as well. The credit is designed to reward companies that invest in innovation, product development, process improvement, or technological advancement. For startups, the credit can even be applied against payroll taxes, offering valuable cash flow support.

Qualifying R&D activities must meet the IRS’s four-part test. These activities must involve the development or improvement of a product, process, technique, invention, or software. The goal of the project must be towards creating a new or improved functionality, or increasing performance, quality, or longevity. The work must be technological in nature, relying on the principles of engineering, computer science, biological science, or physical science, and aim to eliminate uncertainty related to design, capability, or methodology. Lastly, there must be a process of experimentation—such as testing alternatives, evaluating hypotheses, or trial and error. Examples include developing new products, improving existing products or manufacturing processes, or creating custom software.

Qualified Research Expenditures (QREs) are the costs incurred when conducting Qualifying Research Activities (QRAs). They are classified into one of three categories, including:

• Compensation paid to employees for performing QRAs. This includes all taxable wages, such as bonuses and other items reported as Box 1.
• Supplies and materials necessary to conduct qualified research and development that are not depreciated.
• Certain payments made for contract research expenses.

Find out more about what types of activities and expenses can be claimed.

Payroll documentation, general ledgers, employee rosters, and a project list will likely be needed for the calculations, but contemporaneous documentation mapping out QRAs is key. The documentation varies by industry, but typically can be meeting notes, technical specifications, and changes made as the project progressed. For instance, documentation for construction firms and contractors can include job costing reports, Work in Progress (WIP), RFIs, bid documents, marked-up plans, and contracts. For biotech companies, typical documentation that may be evaluated includes employee rosters, payroll records, testing reports, laboratory design layouts, pictures, analytics reports, and other documentation unique for developmental processes. For manufacturers, this could include machine logs, CAD renderings, quotes, BOMs, shop travelers, fabrication drawings, and more. For software, this could include functionality, hardware, architectural, and technical documentation, task lists, code changes, sprints, and more.

The IRS offers two methods that can be used to calculate, the Federal R&D Credit, including the Regular Research Credit and Alternative Simplified Credit (ASC). Under both methodologies, current year expenses must be compared to a historical base period.

Depending on when your company started and record keeping, the Regular Method may be favorable as it yields a higher credit rate compared to ASC. However, for most businesses, ASC’s base period is easier to document as it is the prior three years. Under the regular methodology, the base period depends on when your company started having gross receipts and research activities.

Yes, the R&D Tax Credit can be claimed retroactively, typically through amended tax returns. For federal purposes, taxpayers generally have three years from the original filing date of the return to amend and claim the credit. For pass-through entities, both the corporate and owner’s returns would need to be amended. If your business didn’t claim the credit in prior years but had qualifying activities and expenses, it may be worth reviewing those years for potential savings.