Everything You Need to Know About R&D Tax Credits

The R&D tax credit is a US government incentive that motivates entrepreneurs to register new startups and invest in developing innovative products. Research led by the National Bureau of Economic Research analyzed the number of newly formed companies relative to the year the R&D tax credit went into effect and proved this outcome. After the R&D tax credit went into effect, the average number of newly formed companies went up by ~60%.

Here’s what they concluded: “State-level credits increase average entrepreneurial activity by around 7 percent; counties in states with R&D credits experience a rise in new firm formation of more than 20 percent over 10 years.”

Tax credits like R&D play a pivotal role in driving startup growth, fostering job creation, and contributing to the country's overall economic development.

This guide will teach you everything about the R&D tax credit – What it is, eligibility criteria, ramifications, and more.

What is the R&D tax credit?

The R&D tax credit, established under Section 41 of the Internal Revenue Code, offers a dollar-for-dollar reduction in a company’s federal tax liability for eligible product development, design, or research expenses. 

In simple terms, startups can use the R&D tax credit to reduce the amount of federal tax they owe. If your startup spends money on things like creating and testing new products, improving existing product design, or conducting research, it can qualify for the R&D tax credit. Every year, the US federal government allocates upward of $13 billion in R&D tax credits. 

Apart from the federal government, individual states also offer their own R&D tax credit, the amount of which varies significantly. For example, Maryland has a statutory cap of $12 million for its state-level R&D tax credit program, with a specific allocation for small businesses, whereas California has a cap of $5 million.

The R&D tax credit is introduced to incentivize innovation, both domestically and internationally. The credit applies across industries and is available to companies of any size. It can offset income taxes and, for qualifying startups, employer payroll taxes too.

How to determine eligibility for the credit

Before understanding the R&D tax credit eligibility criteria, it's important to know that no business (or part of a business) is automatically disqualified from claiming this tax credit. 

Your business can be as unique as a brewery yet still be eligible for the R&D tax credit. How? If you plan to use your brewery for experimental brewing, almost everything you do can be eligible for this credit.

Alternatively, if you run a B2B Tech startup and conduct experiments to train AI models or test different algorithms, you can claim the R&D tax credit.

This means anything experimental, from brewing to automation to testing algorithms, is eligible for this tax credit. But there are some rules and eligibility requirements you must pass first.

Before we talk about the rules, there’s one specific scenario where your business won’t be eligible to claim the R&D tax credit. If your entity is a single-member LLC owned by a foreign owner, you can’t claim the R&D tax credit because to claim this credit, your tax residency as an individual must be in the US. The same applies to partnerships.

In the US, partnerships are pass-through entities for tax purposes. This means that the partnership itself doesn’t pay federal income taxes; instead, its income, deductions, and credits are allocated to individual partners based on their ownership interests. Each partner then reports their share on their personal tax return. Only partners who are US taxpayers and subject to income tax can utilize these credits to offset their tax liabilities. Non-US partners, not subject to the US income tax, can’t benefit from these credits.

While partnerships can pass the R&D credit to their partners, the ability to utilize the credit depends on each partner’s tax situation. If a partner doesn’t have sufficient tax liability from the partnership’s income, they may not be able to fully utilize the credit in the current year. However, unused R&D credits can generally be carried forward for up to 20 years, providing opportunities to offset future tax liabilities.

Now, let's talk about the four-part test that helps you determine your eligibility for the R&D tax credit.

Four-part test for the R&D tax credit qualification

To test if your business or part of it is eligible for the R&D tax credit claim, conduct a four-part test. It’s a test built upon the Qualified Research Activities list that the IRS published in 2005.

Part 1. New or improved business component

For your business to pass the first part of the four-part test, the research activities you conduct must focus on developing or improving a business component.

According to the IRA, a business component can be anything you create – a product, process, software, formula, technique, or invention intended for sale, lease, license, or use in your business.

What will qualify you for the tax credit is the intent behind your research. It must aim to enhance the functionality, performance, reliability, or quality of the business component. 

Your improvements don’t have to be groundbreaking, even small incremental changes to your existing product or process are enough to qualify your business for this tax credit.

For example, making changes to your product for a better user experience will count as an improved business component. However, research driven solely by style, taste, cosmetic appeal, or seasonal design won’t qualify. Your focus should be on functional or technological advancements to meet the IRS’s definition of a ‘qualified research expense’ under the Internal Revenue Code (IRC) §41(d)(3)(B).

Part 2. Technological in nature

The second requirement of the four-part test is to make sure that your research activities are grounded in principles of hard science. Meaning, to qualify for the R&D tax credit, your work has to fundamentally rely on the fields of physical sciences, biological sciences, engineering, or computer science.

This test focuses on the research activity and not the end use of the business component. That means painting as a technique won’t qualify as technological in nature, but improving the paint’s formulation to manufacture better durability and shiny paint can meet the criteria.

One thing to keep in mind – activities grounded in the ‘soft sciences’ like psychology or sociology generally don’t qualify, even if they follow a hypothesis-driven approach.

Part 3. Elimination of uncertainty

In this part, you are expected to confirm that your research activities aim to address technical uncertainties related to your product or process. This means the work you’re doing must answer questions about design, methodology, or feasibility.

Some common uncertainties you should answer are:

• Can you design or build a completely new product?
• How should the product be designed to meet specific goals?
• Will it be feasible to improve the existing product?
• How can you refine the process to make it more efficient?

The goal with this part isn’t to confirm what you already know, instead, it’s to tackle the unknown in the process of designing or building your product.

Even if, for some reason, your R&D fails, it can still qualify for the R&D tax credit, as long as all the four parts of this test are met.

Part 4. Process of experimentation

To meet the criteria for the process of experimentation, your research activities should involve a systematic experimentation process that aims at resolving technical uncertainties. This part focuses on exploring alternatives, testing hypotheses, and improving the methods you use to achieve the outcome.

For instance, if you develop software to meet the process of experimentation, your process must involve testing different algorithms or code iterations to improve functionality. In manufacturing, it could mean refining prototypes to reduce costs and improve durability.

To claim the R&D tax credit, you must show the government that your focus is on active experimentation, not merely on following established procedures to get the expected output. 

Let The Little Sandy Coal Company, Inc. v. Commissioner of Internal Revenue case serve as a cautionary tale. Little Sandy Coal (LSC) is the parent entity of a shipbuilding company that claimed the R&D tax credit in 2014. They had designed and constructed 11 first-in-class vessels and claimed employee wages, third-party wages, and supply costs. The Credit was disallowed by the US Tax Court in 2021, and the subsequent appeal affirmed the Tax Court’s decision, largely due to their failure to prove that the research activity involved a Process of Experimentation. 

Common exclusions from the R&D tax credit

While the R&D tax credit is designed to reward innovation, certain activities are explicitly excluded from qualification, even if they seem to align with the four-part test.

1. Foreign research

Research conducted outside of the US or Puerto Rico doesn’t qualify for the R&D tax credit, even if it’s performed by American researchers or funded by an American company. IRA launched this credit to incentivize domestic innovation, so any in-house or contract research performed abroad will be excluded.

2. Funded research

Research that’s funded by a third party is automatically ineligible for this credit. However, research is not considered funded if the business:

• Bears the economic risk for the research (i.e., payment is contingent upon the success of the project).
• Retains substantial rights to the result of the research.

If either of the two conditions aren’t met, the activity will be classified as funded and will be excluded from eligibility.

3. Adaptation of an existing business component

If you make modifications to your existing product, process, or software to fit a customer’s specific needs, it won’t qualify for the R&D tax credit. For example, if a SaaS company customizes its CRM to include specific fields or workflows requested by some client, the activity will be considered as adaptation and not experimental.

4. Routine efficiency and management tasks

Administrative and routine efficiency-related activities are excluded from the tax credit. These can be tasks like:

• Employee training programs or organizational planning.
• Process updates driven by management decisions rather than technological advancement.
• Efficiency surveys or performance evaluations.

The above functions, while valuable to a business, are not aimed at resolving technical uncertainties or advancing technology.

The process to claim the R&D Tax Credit

The process begins with collecting all the documents you need to claim the R&D tax credit. Since the IRS requires your business to prove that your research activities qualify, you need relevant documents to back it up.

It’s no secret that claiming the R&D tax credit is a tedious and time-consuming job. You have to go through the eligibility criteria to identify if your expenses qualify, prepare all your documents, fill out forms, and do so much more.

Firstbase Tax Filing saves you this hassle by doing the process for you and doing much more. If you’re eligible for the credit, the platform ensures you get the maximum R&D tax credit at an industry-leading cost (invoiced separately). The R&D tax credit process costs 15% of your successfully claimed tax credit.

Documents required to claim the R&D tax credit

1. Employee wage documentation

Keep records of all the wages you pay to the employees involved in the R&D of the product or process. The documents you need to claim the credit later are:

• W-2 forms: The wage and tax statement forms document the wages you pay to employees. You will need these forms to show how much you paid for the R&D activities.
• Timesheets: Helps track the number of hours employees spend on qualified research activities.
• Payroll registers: Provides an overview of wages and salaries paid during the tax year and will help support your claim.

2. Contractor expense documentation

If you have hired a contractor to do the R&D for you, the contractor expense documentation is the part where you collect all the information related to your contractor.

• 1099 form: You use the 1099 form as proof of the expense you give to self-employed individuals and other entities that aren’t your company’s full-time employees.
• Invoices: The monthly or project-basis invoices raised by your contractor for the R&D-related work they did for you.
• Contracts: Signed agreements that detail the scope of work related to qualified research activities.

3. Suppliers and materials documentation

All materials used in the research and development process need to be documented properly. You need every material receipt and invoice and a general ledger entry. This means that your accounting records should reflect the expenses incurred for qualified research projects.

4. Lease and rent agreements for research equipment

If you lease or rent equipment for research purposes, the IRS requires documentation to show these expenses were necessary for your R&D activities. This includes:

• Lease agreements or rental contracts: Important for outlining the terms of equipment usage.
• Usage logs: Important to demonstrate the equipment that was used specifically for R&D activities.

Form 6765 – What is it and how to fill it out

Form 6765, Credit for increasing research activities, is the form you have to file with the IRS to claim the R&D tax credit. As a part of the process, you have to identify qualifying expenses and provide adequate documentation that shows how these costs meet the requirements under the Internal Revenue Code Section 4.1. 

The form has 4 sections that you must fill out.

Section A – Regular Credit

Section A is used to calculate the regular method of claiming the R&D tax credit. This involves identifying and documenting qualifying research expenses like wages, supplies, and contracted research. The section also compares the research expense to the base amount to determine the incremental increase in research activities.

You can skip filling out this section if you have elected alternative simplified credit (ASC) – a simpler calculation method offered in Section B of the form.

Documents needed for Section A:

• Wage records showing wages for employees involved in qualified research.
• Invoices or expense reports for supplies used directly in R&D.
• Contracts and payment records for outsourced R&D services.
• Annual gross receipts for at least the past four years (to calculate base amounts) and qualified research expenses for prior years (to establish the qualified organization base amount in line 3).
• Computer lease agreements if leasing computers for R&D.
• Documentation supporting the fixed-base percentage (not exceeding 16%).

Section B – Alternative Simplified Credit

Section B lets you claim the R&D tax credit without the need to calculate a fixed-base percentage or have detailed historical data on research expenses for a base period. Instead, the credit is based on a percentage of the average qualified research expenses over the past 3 tax years. 

Skip Section A and fill out Section B if your business has incomplete historical records or is new to R&D activities and doesn’t have a long history of research expenses.

Documents needed for Section B:

• Wages for employees and supply costs directly related to R&D.
• Contract research costs (e.g., payments to third parties for R&D).
• Computer rental or lease costs, if applicable.
• Records of R&D spending for the previous three years to calculate the three-year average. If you had no qualified research expenses in any one of those years, skip lines 30 and 31 
• Energy consortia payments or basic research payments, if applicable.

Section C – Current Year Credit

Section C is a non-skippable section that consolidates information from earlier sections and incorporates other tax rules to finalize the credit amount your business can claim for the current year.

This section focuses on adjusting credits that overlap with wages used for other tax benefits (for example, payroll tax credit or work opportunity tax credit).

Documents required for Section C:

• Fill out and submit Form 8932 if the credit includes wages that were also used to calculate other tax benefits.
• Have your Schedule K ready if you are filing as a partnership or S corporation. 
• If you’re allocating credit to beneficiaries, gather documents showing the allocations.
• If the credit is based on wages, ensure you have documentation that these wages weren’t used for other overlapping credits.
• Fill out form 3800 to report the credit for eligible small businesses.

Section D – Qualified Small Business Payroll Tax Election and Payroll Tax Credit

Section D is designed for qualified small businesses (QSBs) that want to elect the payroll tax credit instead of carrying the R&D tax credit forward or applying it against income tax. This is particularly useful if your startup doesn’t have significant taxable income, as it allows you to reduce payroll tax liabilities up to $500,000 annually.

To qualify for Section D, though, you must:

• Have gross recipes of less than $5 million in the current tax year.
• Didn’t have gross receipts for any tax year preceding the previous 5 years.

Documents required for Section D:

• Gross receipts records to back all your financial statements or tax returns to prove your business meets the QSB definition.
• Form 8932 or similar documentation if part of the credit is based on wages used for other payroll-related credits.
• Form 3800 as a referral for credit calculations.
• Payroll tax records as proof of payroll tax liabilities to ensure the credit is applied correctly.
• Records of general business credit carryforward amounts from prior years. 

Ramifications of claiming the R&D tax credit

Although claiming the R&D tax credit provides significant benefits to a business, it also comes with some potential ramifications.

• Claiming the R&D tax credit might increase scrutiny from the IRS due to the complex nature of the credit.
• To claim the credit, you must keep records for the entire statute of limitations period, which is typically three years. However, if the IRS suspects fraud or significant understatement of tax liability, the period can be longer.
• The process is prone to errors in identifying qualified expenses like adding costs unrelated to R&D, which can result in denied claims and penalties.
• Take extra care when you claim wages in the R&D tax credit. Don’t forget to double-check and ensure you’re not claiming those wages in any other credit.
• If your business undergoes a significant ownership change, you may lose the ability to carry forward unused R&D credits.

How Firstbase Tax Filing helps startups claim the R&D tax credit

The US government allocates billions of dollars each year for companies to claim the R&D tax credit, but it’s not that straightforward to claim the credit. You need specific documents and long-term financial records to do so.

One of the features of Firstbase Tax Filing is to help you claim the maximum R&D tax credit, provided you’re eligible. Just provide us with all the information and documents needed for the claim process, and we will do the procedure for you.

To do the procedure and save you the hassle and time, we charge a flat fee of 15% of the total tax credit claimed by your company. 

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