Research and development tax credit: What it is and how to claim it

The research and development tax credit is one of the most valuable—and underutilized—tax benefits available to businesses that invest in innovation. Yet nearly 25% of companies have lost R&D tax credits due to inadequate documentation. Understanding what qualifies and how to claim the credit can mean significant tax savings for your organization.

This guide explains the R&D tax credit, what expenses qualify, how to calculate your credit, and why accurate time tracking is essential for defending your claims against IRS scrutiny.

What is the research and development tax credit?

The research and development tax credit—formally known as the Credit for Increasing Research Activities—is a federal tax incentive under Section 41 of the Internal Revenue Code. It provides a dollar-for-dollar reduction in tax liability for businesses that conduct qualified research in the United States.

Originally enacted in 1981 and made permanent by the Protecting Americans from Tax Hikes Act of 2015, the R&D tax credit encourages domestic research by reducing the cost of innovation. Unlike a deduction that reduces taxable income, this credit directly reduces the taxes you owe.

For qualified small businesses, the credit can even offset payroll tax obligations—making it valuable for startups that don't yet have significant income tax liability.

What qualifies as research and development for the tax credit?

Not all business activities qualify for the R&D tax credit. The IRS applies a four-part test to determine whether your research activities meet the requirements:

• Permitted purpose: The research must aim to develop a new or improved business component—a product, process, software, technique, formula, or invention
• Technological in nature: The research must rely on principles of physical science, biological science, engineering, or computer science
• Technical uncertainty: You must face uncertainty about the capability, method, or design for achieving the result
• Process of experimentation: You must evaluate alternatives through modeling, simulation, systematic trial and error, or other methods

Qualified research activities span many industries beyond traditional laboratories. Software development, manufacturing process improvements, engineering design, and product development often qualify—even when the underlying technology isn't cutting-edge.

What expenses qualify for the R&D tax credit?

The credit applies to four categories of qualified research expenses:

Wages for qualified services: Compensation paid to employees who directly perform, supervise, or support qualified research. This typically represents the largest component of most R&D credit claims.

Supplies: Tangible property used and consumed in the research process, excluding capital equipment and general administrative supplies.

Contract research expenses: Payments to third parties for qualified research conducted on your behalf. Generally, 65% of contract research expenses qualify for the credit.

Basic research payments: Payments to qualified organizations (universities, scientific organizations) for basic research.

Research and development expenses that don't qualify include market research, quality control testing for commercial production, social science research, and research conducted outside the United States.

How is the R&D tax credit calculated?

Businesses can calculate their credit using one of two methods:

Regular credit method: The credit equals 20% of qualified research expenses above a base amount. The base amount is calculated using your historical research spending as a percentage of gross receipts. This method benefits companies with consistent research investment over time.

Alternative simplified credit: The credit equals 14% of qualified research expenses exceeding 50% of your average qualified research expenses for the three preceding tax years. Companies without adequate historical records or those new to R&D often use this method.

For tax year 2025 and beyond, the One Big Beautiful Bill Act has restored immediate expensing for domestic research and experimental expenditures under Section 174, eliminating the five-year amortization requirement that had been in effect.

Who qualifies for the research and development tax credit?

Any business that conducts qualified research activities and incurs qualified research expenses may claim the credit. Common industries include:

• Software and technology companies developing new applications or improving existing systems
• Manufacturing firms improving production processes or developing new products
• Engineering and architecture firms solving technical design challenges
• Life sciences and pharmaceutical companies conducting clinical research
• Aerospace and defense contractors developing new technologies
• Food and beverage companies improving formulations or processes

Small businesses with gross receipts under $5 million and no gross receipts for any tax year before the five-year period ending with the current tax year can apply up to $500,000 of the credit against payroll tax liability. This makes the credit accessible to startups that haven't yet achieved profitability.

How to claim the R&D tax credit

To claim the credit, businesses must complete IRS Form 6765, Credit for Increasing Research Activities, and attach it to their income tax return.

The form requires detailed information about your qualified research expenses, including:

• Total wages paid for qualified services
• Total qualified supply expenses
• Total contract research expenses
• Rental or lease costs of computers used in research
• Calculation of base amount (for regular credit method)
• Average qualified research expenses for prior years (for alternative simplified credit)

The IRS has increased scrutiny of R&D credit claims in recent years. Proposed changes to Form 6765 require more detailed reporting of business components—the specific products, processes, or software being developed—along with documentation of the technical uncertainty being resolved.

Why documentation matters for R&D tax credits

The R&D tax credit is only as defensible as your documentation. When the IRS examines credit claims, they look for contemporaneous records that demonstrate:

• Who performed qualified research activities and for how many hours
• What technical uncertainty existed and what experiments were conducted
• When the research occurred relative to the development timeline
• How labor costs were allocated to specific business components

Without audit-ready records, companies face credit disallowance or reduction. ClickTime's research shows that 23% of organizations have faced audit failures from poor labor cost records, and nearly 25% have lost R&D tax credits due to inadequate documentation.

The challenge: engineering teams often operate as a "black box" to finance. Controllers can see total development costs but can't prove how those hours break down by project, phase, or business component—exactly what the IRS now requires.

How accurate time tracking protects your R&D tax credits

Reliable time data forms the foundation of a defensible R&D credit claim. When employees track time against specific projects and activities, you create the contemporaneous documentation the IRS expects.

CapEx labor tracking and R&D time tracking systems help finance teams:

• Capture hours by business component: Track time against the specific products, processes, or software that qualify for the credit
• Identify qualifying activities: Distinguish between qualified research activities and excluded activities like routine testing or market research
• Allocate wages accurately: Calculate the portion of employee compensation attributable to qualified research
• Generate audit-ready reports: Produce finance-ready documentation that satisfies IRS examination requirements

The difference between estimates and verified time records can mean the difference between defending your credit and losing it under audit.

Are R&D tax credits available at the state level?

Beyond the federal research credit, many states offer their own R&D tax incentives. Over 30 states provide some form of R&D credit, though eligibility requirements, credit rates, and carryforward provisions vary significantly.

Some states offer refundable credits, making them valuable even for businesses without state tax liability. Others allow credits to be sold or transferred. Detailed reporting capabilities help organizations track qualified research expenses by location to maximize both federal and state credit claims.

Common mistakes when claiming R&D tax credits

Companies frequently leave tax savings on the table or expose themselves to audit risk through these errors:

Underestimating qualifying activities: Many businesses assume the credit only applies to laboratory research. In reality, software development, process improvements, and product design often qualify.

Relying on estimates instead of records: Using management estimates or allocation percentages rather than actual time records weakens your documentation and increases audit risk.

Missing the wage allocation: Failing to properly allocate employee wages between qualified and non-qualified activities can result in understated credits or IRS challenges.

Inadequate project documentation: Not maintaining records of technical uncertainty, experimentation process, and business component definitions leaves credits vulnerable to disallowance.

Forgetting open tax years: Businesses can amend returns for open tax years to claim credits not taken in prior periods. Depending on your situation, you may be able to claim credits for research conducted three or more years ago.

Getting started with R&D tax credits

If your business invests in developing new products, improving processes, or creating software, you may qualify for significant tax savings through the research and development tax credit.

Start by documenting your research activities and the technical uncertainties you're working to resolve. Implement time tracking that captures hours by project and activity. Work with tax professionals who specialize in R&D credits to maximize your claim while building documentation that withstands IRS scrutiny.

The credit is available—but only for businesses that can prove they earned it.