Here’s something that still surprises business owners after all these years: 90% of R&D tax credit claims come from small and mid-sized businesses (Boast 2026 Benchmark Report). Not Fortune 500 companies. Not pharmaceutical giants. Businesses like yours.
Yet the most common thing I hear from business owners is, “We don’t do R&D.” After 25 years helping companies claim this credit, I can tell you that assumption is leaving real money on the table. If your team solves technical problems, tests new approaches, or improves how things are made — there’s a strong chance you qualify.
So what exactly is this credit, who qualifies, and what changed in 2025? Let’s break it down.
Key Takeaways
- The average R&D credit claim reached $768,233 in 2024 — a 245% increase since 2018 (Boast, 2026)
- Your activities must pass the IRS four-part test under IRC §41 — but you don’t need a formal R&D department
- The OBBBA (July 2025) restored immediate R&D expensing under new Section 174A — with a July 6, 2026 deadline for small business retroactive elections
- Startups can offset up to $500,000 in payroll taxes using the credit, even with zero income tax liability
What Is the R&D Tax Credit and Why Does It Matter?
Companies across North America secured more than $900 million in R&D tax credits in 2024, with the average claim value reaching $768,233 — up 245% since 2018 (Boast, 2026). The federal R&D tax credit, formally known as the Credit for Increasing Research Activities under IRC §41, provides a dollar-for-dollar reduction in your tax liability for qualified research expenses.
First introduced in 1981, it became a permanent part of the tax code through the Protecting Americans from Tax Hikes (PATH) Act of 2015. It’s designed to reward businesses that increase their investment in research activities on U.S. soil — and it’s available to companies of every size and industry.
Two calculation methods: The Regular Research Credit (RRC) equals 20% of QREs exceeding a calculated base amount. The Alternative Simplified Credit (ASC), which most businesses use, equals 14% of QREs exceeding 50% of the average QREs for the three prior tax years. For businesses with no prior-year QREs, the ASC is 6% of current-year expenses.
How Does the IRS Four-Part Test Work?
The IRS requires each claimed activity — applied separately to each “business component” — to satisfy a four-part test under Section 41(d). The Tax Court has called the R&D credit one of the most complicated provisions in the Code, noting it was the most commonly reported uncertain tax position on Schedule UTP for three consecutive years. Understanding this test is the single most important step in evaluating your eligibility.
| Test | What It Means for Your Business |
|---|---|
| 1Section 174 Test | Your expenses must be incurred in connection with your trade or business and represent R&D costs in the experimental or laboratory sense. The activity must aim to eliminate uncertainty about developing or improving a product, process, or other business component. |
| 2Technological in Nature | Research must rely on principles of the hard sciences — engineering, physics, chemistry, biology, or computer science. Style, taste, and cosmetic factors are excluded. But don’t confuse “technological” with “high-tech” — a manufacturer improving a production process is applying engineering principles. |
| 3Elimination of Uncertainty | When your team started the work, they didn’t already know if the approach would succeed, how to achieve the result, or what the optimal design should be. If the answer was known before work began, it doesn’t qualify. |
| 4Process of Experimentation | At least 80% of the research activities must involve evaluating alternatives — through modeling, simulation, systematic trial and error, or testing hypotheses. This is the “substantially all” requirement under Treas. Reg. §1.41-4(a)(6). |
“The research credit is one of the most complicated provisions in the Code. Its complexity is evidenced by the fact that it was the most commonly reported uncertain tax position on Schedule UTP.”
— U.S. Tax Court
What Expenses Can You Actually Claim?
The IRS defines qualified research expenses as the sum of in-house research expenses and contract research expenses (IRS Form 6765 Instructions, 2025). Once your activities pass the four-part test, three categories of costs become claimable. Here’s what counts — and a common mistake I see businesses make with each one.
Employee Wages
Wages for employees who directly perform, supervise, or support qualified research. Key IRS rule: if 80%+ of an employee’s work qualifies, their entire annual wages count as QREs — not just the qualifying portion.
Supplies
Tangible property consumed in research — prototypes, raw materials, testing supplies. Common miss: cloud computing costs used for R&D now qualify as supply expenses under recent IRS guidance.
Contract Research
65% of payments to third parties performing research on your behalf. Watch out: you must bear the financial risk and retain substantial IP rights, or the expense doesn’t qualify.
What Doesn’t Qualify? The IRS Exclusion List
Section 41(d)(4) explicitly excludes several categories from the credit. Knowing these boundaries is just as important as knowing what qualifies — because claiming excluded activities is one of the fastest ways to trigger an audit.
Activities that never qualify: research conducted after commercial production begins, adapting an existing product for a specific customer’s needs, duplicating an existing product from physical examination or publicly available specifications, efficiency surveys and management studies, market research, research conducted outside the United States, and research in the social sciences, arts, or humanities.
A critical distinction: “After commercial production” doesn’t mean all post-launch work is excluded. Improvements, new features, and next-generation development on an existing product can qualify — as long as the new work itself involves technical uncertainty and experimentation. The exclusion targets routine production activities, not ongoing innovation.
What Changed With the 2025 OBBBA?
2025 Legislative Update
The One Big Beautiful Bill Act, signed July 4, 2025, reversed one of the most disruptive provisions of the 2017 Tax Cuts and Jobs Act. Since 2022, the TCJA had forced all businesses to capitalize and amortize domestic R&D costs over five years — creating significant cash flow pain for every R&D-intensive company in America. The OBBBA created new Section 174A, permanently restoring immediate expensing for domestic R&D (Grant Thornton, 2025).
OBBBA Transition Rules — Critical Deadlines
All businesses: Deduct 2022–2024 costs nowYou can deduct remaining unamortized domestic R&D costs either entirely in 2025 or split across 2025–2026. No amended returns needed — this is a method change on your 2025 return per Rev. Proc. 2025-28.
Small businesses: Retroactive electionCompanies with average annual gross receipts of $31 million or less can apply Section 174A retroactively to 2022–2024 by amending returns. Hard deadline: July 6, 2026.
Section 280C coordination restoredThe OBBBA restored the pre-TCJA choice: claim the full credit and reduce your deduction, or elect a reduced credit and keep the full deduction. Model both — the right answer depends on your specific tax position.
Can Startups Use the R&D Credit?
Yes — and it’s one of the most underutilized provisions in the code. Under IRC §41(h), qualified small businesses can apply up to $500,000 of the R&D credit against their employer-portion Social Security taxes (IRS Form 6765 Instructions). This makes the credit immediately valuable for pre-revenue companies with zero income tax liability.
To qualify, a business must have gross receipts under $5 million for the credit year and no gross receipts in any tax year before the five-year period ending with the credit year. If you’re a startup burning through cash on product development, this provision can put real money back into your operating account every quarter.
Are You Ready for Mandatory Form 6765 Section G in 2026?
The IRS has introduced a new Section G on Form 6765 requiring detailed business component-level reporting (The Tax Adviser, 2025). For 2025 returns, Section G is optional. Starting with tax years beginning after December 31, 2025, it’s mandatory.
What you’ll need to report: identification of each business component, description of research activities performed, names or titles of individuals who performed the research, and total qualified expenses broken down by wages, supplies, and contract research — per business component.
Does Your Business Qualify? A Quick Self-Assessment
Software and internet companies represent 80.6% of all R&D credit claims and have the lowest audit rate at 5.28% (Boast, 2026). But they’re far from the only industry that qualifies. The key isn’t your industry — it’s whether your technical people are solving problems that involve uncertainty and experimentation.
Your business likely qualifies if you:
- Develop or improve products, processes, software, formulas, or techniques
- Encounter technical challenges where the solution isn’t immediately known
- Evaluate alternatives through testing, modeling, simulation, or trial and error
- Employ engineers, developers, scientists, or technical staff who solve problems
- Invest in automation, new manufacturing methods, or process improvement
- Build or improve software applications, platforms, or internal tools
- Design new products or components that require technical evaluation
At Tax Formulations, we’ve helped businesses across dozens of industries identify and claim more than $150 million in federal and state R&D tax credits. Our team brings Big Four experience and a hands-on approach from initial qualification assessment through audit defense. In our experience, the companies that benefit most from this credit are the ones that assumed they didn’t qualify.
Not Sure If Your Business Qualifies?
We’ll evaluate your activities and give you a straight answer — no cost, no obligation.
Frequently Asked Questions
What is the R&D tax credit worth to my business?
Under the Alternative Simplified Credit method, the effective credit typically works out to 6–8% of qualifying R&D spending for established businesses. The 2026 Boast Benchmark Report found the average claim reached $768,233 in 2024. Your actual value depends on qualifying expenses and calculation method — contact us for a free estimate.
Can I claim R&D credits for prior tax years I missed?
Yes. You can amend returns within the standard three-year statute of limitations. With the OBBBA’s transition rules, small businesses (under $31M gross receipts) can also retroactively apply Section 174A expensing to 2022–2024 returns — but the deadline is July 6, 2026. [INTERNAL-LINK: amended returns guide → future post on claiming R&D credits retroactively]
Do I need a formal R&D department to qualify?
No. The IRS evaluates qualifying activities based on what employees actually do — not on org charts, job titles, or department names. Many of our clients have no formal R&D team; their engineers, developers, and production staff perform qualifying research as part of their daily work.
Does the R&D credit increase my audit risk?
The R&D credit has historically been among the most scrutinized credits. But a well-documented study dramatically reduces risk. Software companies — the highest-volume claimants — had only a 5.28% audit rate in 2024 (Boast, 2026). Every study Tax Formulations delivers is built to withstand IRS examination. [INTERNAL-LINK: audit defense → future post on R&D audit preparation]
Can I claim both the R&D credit and the Section 174A deduction?
Yes. Taxpayers can use the §41 credit alongside the §174A deduction — but Section 280C(c) prevents double-dipping. You must either reduce your deduction by the credit amount, or elect a reduced credit and keep the full deduction. Your advisor should model both scenarios for your specific situation. [INTERNAL-LINK: 174A coordination → future post on Section 174 amortization changes]
What Should You Do Next?
If you’ve read this far, here’s the honest truth: the window for some of these opportunities is closing. The July 6, 2026 deadline for small business retroactive elections is less than four months away. The 2025 tax filing season — your first chance to use Section 174A on an original return — is underway. And the new Section G documentation requirements will become mandatory before you know it.
Don’t let another year pass without evaluating whether your business qualifies. Reach out for a free consultation — we’ll review your activities, give you a straight answer on eligibility, and if there’s a credit to claim, we’ll build a study that maximizes your savings and stands up to audit.