Every small business owner should know what expenses qualify for R&D tax credits.
If this is new territory for you, let me explain the basics.
Research and development (R&D) tax credits provide dollar-for-dollar cash savings for activities related to the development, design, or improvement of products, processes, or software.¹
Many business owners think that these credits are limited to scientific research that’s confined to a laboratory. That’s not the case.
R&D tax credits are more broad than you may realize. They include
- Designing software;
- Developing new products;
- Improving an existing product;
- Testing a product or process;
- Environmental or certification testing;
- Building facilities; and
- Wages to research and development employees.
Yes — even paying wages to employees or contract workers engaged in research can qualify for a tax credit.
The R&D credit has been around for 40 years.
The R&D Tax Credit was introduced in 1981 as part of the Economic Recovery Tax Act. The goal was to drive innovation and promote job growth. Since then it’s been extended 15 times. Congress made it a permanent part of the U.S. tax code in 2015.
The IRS uses a four-part test to determine if expenses are eligible for R&D credits.
So many expenses qualify for R&D tax credits that it can be difficult to keep track of the possibilities. Rather than list every potential expense, it’s easier to give you the method the IRS uses to determine what’s eligible.
Specifically, they use a four-part test to determine whether a project qualifies:
- New or Improved Business Component Developed for a Permitted Purpose
- Elimination of Uncertainty
- Process of Experimentation
- Technological in Nature²
So, if you’ve got a project that meets the first three, but it isn’t technological in nature, you can’t claim the credit.
Here’s a short list of expenses that don’t qualify for R&D tax credits.
Unfortunately, some expenses that do pass the four-part test still don’t qualify for R&D tax credits. You can view the entire list of exclusions² on the IRS website, but here are some highlights:
- Duplication of Existing Business Components
- Reverse Engineering
- Routine Testing & Quality Control
- Research Conducted Outside the United States
If you aren’t sure if one of your expenses qualifies, ask a CPA. They’ll be able to tell you what’s eligible. More importantly, they can help you get set up to take advantage of more R&D tax credits in the future.
Use R&D tax credits to reduce payroll taxes.
As of 2023, certain small businesses can also claim an R&D tax credit of up to $500,000 per year against their payroll taxes. To be eligible, your business must have less than $5 million in gross receipts and fewer than five years of gross receipts.
Up until 2022, the credit was for only $250,000. Now, it’s double that at $500,000. Take advantage if you can.
Not enough businesses claim these credits.
According to one study, fewer than 3 in 10 qualifying small businesses claim an R&D tax credit.³ You don’t want to be one of the ones who leave money on the table.
Start preparing to claim credits now.
You can claim federal R&D tax credits by using Form 6765. Depending on where you live, you might also be eligible for a local credit for your state.
Contact Jeremy A. Johnson, CPA for help with R&D tax credits.
If you still have uncertainties about what expenses qualify for R&D tax credits, you’re not alone. As I’ve said, the best thing to do is meet with someone with experience in tax credits.
I’m a Fort Worth-based CPA with more than a decade of experience helping businesses like yours reduce their tax liability.
Jeremy A. Johnson, CPA
- IRS. Research Credit. Irs.gov. Available from: https://www.irs.gov/businesses/research-credit
- IRS. Audit Techniques Guide credit for increasing research activities i.e. research tax credit IRC 41 qualified research activities. Irs.gov. Available from: https://www.irs.gov/businesses/audit-techniques-guide-credit-for-increasing-research-activities-i-e-research-tax-credit-irc-41-qualified-research-activities
- Emily Heaslip. How to qualify for and claim the R&D tax credit. CO. The U.S. Chamber of Commerce. Available from: https://www.uschamber.com/co/run/finance/research-and-development-tax-credit