Businesses that invest in innovation and development may be eligible for a valuable federal tax incentive: the research and development (R&D) tax credit. While the rules can be complex and not every activity qualifies, the potential tax savings can be substantial. Below are answers to some of the most frequently asked questions about this opportunity.
What Is the R&D Tax Credit Worth?
The federal R&D tax credit is designed to reward companies that increase their research activities. In most cases, the credit equals 20% of the amount by which your qualified research expenses exceed a calculated base amount tied to your historical spending.
There are alternative calculation methods available, particularly for start-ups or businesses without sufficient historical data.
Qualified research expenses (QREs) typically include:
- Employee wages related to research activities
- Supplies used during development
- Certain contractor and consulting costs
This credit is nonrefundable, meaning it cannot create a tax loss. However, unused credits can be carried back one year or forward for up to 20 years. Additionally, general business credit limitations prevent companies from eliminating their entire tax liability using credits alone.
Start-ups may also benefit by applying up to $500,000 of the credit against employer payroll taxes. Generally, this applies to businesses under five years old with less than $5 million in gross receipts.
Owners of pass-through entities — such as partnerships, S corporations, and most LLCs — may use the credit to reduce alternative minimum tax (AMT) liability, provided the business meets the small business threshold (typically $50 million or less in average gross receipts over three years).
What Expenses Qualify for the Credit?
The R&D tax credit extends beyond traditional laboratory research. To qualify, activities must meet several criteria:
- They must involve developing or improving a product, process, software, or technique
- They must address uncertainty regarding the development or improvement
- They must include a process of experimentation, such as testing, modeling, or trial and error
- They must be technological in nature, relying on disciplines like engineering, physics, or computer science
Additionally, businesses must bear the financial risk and retain rights to the results. If the research is funded by another party, it typically does not qualify.
Eligible activities can include:
- Creating new products
- Enhancing production or operational processes
- Developing internal-use software
Only domestic research expenses are eligible for the federal credit. Foreign research costs must be capitalized and amortized over 15 years instead.
Can You Claim Both the R&D Credit and R&E Expense Deductions?
Research-related spending may qualify for two types of tax benefits:
- The R&D tax credit
- The deduction for research and experimental (R&E) expenses
For tax years beginning after December 31, 2024, businesses can immediately deduct domestic R&E expenditures. However, you cannot claim both the deduction and the credit on the same expenses.
If you choose to claim the R&D credit, you must reduce your deductible R&E expenses by the amount of the credit. Under current law, this reduction equals the full amount of the credit, simplifying prior calculation rules.
What Should Businesses Do Next?
Because of its complexity, many companies miss out on the R&D tax credit. However, the financial benefits can be significant. In addition to federal incentives, many states also offer their own research-related tax credits.
If your business is developing or improving products, processes, or software, it may be worthwhile to evaluate your eligibility. Proper documentation and calculation are essential to maximizing benefits and ensuring compliance.
Professional guidance can help you identify qualifying activities, calculate your credit accurately, and support your claim with proper documentation.