A Practical Guide to the U.S. R&D Tax Credit

January 23, 2026

1. What Is the R&D Tax Credit?

The R&D Tax Credit (formally the Credit for Increasing Research Activities under Internal Revenue Code §41) is a dollar-for-dollar federal tax credit designed to incentivize businesses to invest in research and development in the United States. Unlike deductions, which reduce taxable income, a tax credit directly reduces a company’s tax liability.

The credit rewards businesses for engaging in US-based qualified research activities (QRAs) by allowing them to claim a portion of eligible research costs—called Qualified Research Expenses (QREs)—as a credit against federal taxes.

2. Who Can Claim the R&D Tax Credit?

Nearly all business structures can qualify, provided they conduct qualified research activities in the U.S. This includes:

  • Sole proprietors
  • Partnerships and LLCs
  • S-corporations
  • C-corporations

While the credit generally offsets income tax liability, certain early-stage companies with little or no taxable income can elect to apply the credit against payroll taxes (discussed in Section 5).

3. Which R&D Activities Qualify for the Credit?

To qualify, research activities must satisfy ALL PARTS of the following IRS Four-Part Test. Failure to meet even one test disqualifies the activity.

3.1. Permitted Purpose

The research must seek to develop a new or improved business component, such as a product, process, technique, formula, invention, or software. The improvement must relate to functionality, performance, reliability, or quality—not merely cosmetic or aesthetic changes.

Example:

Developing an automated quality control system using computer vision to improve defect detection on a production line—raising accuracy from 92% to 98% and reducing manual inspection labor—satisfies the permitted purpose test.

3.2. Elimination of Uncertainty

At the outset of the project, there must be technical uncertainty regarding the capability, method, or design of achieving the intended result.

Example:

In the quality control project, uncertainties may include:

  • Whether machine vision could reliably identify subtle defects on reflective metal parts
  • Whether the system could integrate with existing conveyor belt speeds without major hardware changes

These uncertainties were addressed through iterative model training, hardware testing, and evaluation of both off-the-shelf and custom software solutions.

3.3. Process of Experimentation

The research must involve a systematic process of experimentation, such as testing alternatives, modeling, simulation, prototyping, or trial-and-error.

Example:

The research team:

  • Tested multiple image recognition libraries
  • Experimented with lighting setups and sensor placement to reduce glare
  • Adjusted conveyor speeds and camera shutter timing across repeated trials
  • Documented test results and compared defect detection metrics

This iterative approach satisfies the experimentation requirement.

3.4. Technological in Nature

The activity must rely on principles of the hard sciences, such as engineering, computer science, physics, chemistry, or biology.

Example:

The quality control system relies on computer science (machine learning), mechanical engineering, and physics (optical sensor calibration), satisfying this requirement.

4. How the R&D Tax Credit Works

The credit is calculated based on Qualified Research Expenses (QREs) incurred in qualified research activities. There are three categories of QREs:

4.1. W-2 Wages

Qualified wages include W-2 compensation paid to employees who:

  • Directly perform qualified research
  • Directly supervise qualified research
  • Directly support qualified research

Only the portion of wages attributable to U.S.-based qualified research activities may be included.

Example:

If John Doe earns $120,000 annually and spends 80% of his time on qualified research performed in the U.S., then: 80% × $120,000 = $96,000 of QRE wages

Note: Citizenship does not matter. However, work performed outside the U.S. does not qualify, even if paid on a W-2.

4.2. Supplies

Supplies include tangible property consumed in the conduct of qualified research. Capital equipment and general office supplies do not qualify.

Example:

Optical sensors costing $4,500 and consumed during prototype testing may be included as QREs.

4.3. Contract Research Expenses

Payments to third parties for qualified research may be included as QREs only if:

  • The research would qualify if performed by the taxpayer
  • The taxpayer bears the financial risk
  • The taxpayer retains substantial rights to the research results
  • The research is performed within the United States

Only 65% of eligible contract research costs may be included as QREs.

Example:

If a U.S.-based university professor is paid $10,000 to perform qualifying research under a consulting agreement, then: 65% × $10,000 = $6,500 of QREs

5. Application of the Credit: Income Tax vs. Payroll Tax Offset

5.1. Income Tax Offset (Default)

The R&D tax credit is generally used to offset federal income tax liability. Unused credits may be carried forward.

5.2. Payroll Tax Offset for Qualified Small Businesses

Qualified small businesses (QSBs) may elect to apply the credit against payroll taxes instead of income tax. A business qualifies if it has less than $5 million in gross receipts for the credit year and has no more than five tax years of gross receipts. Eligible businesses may apply up to $500,000 per year of the R&D credit against the employer’s share of Social Security tax. This election can be especially valuable for early-stage startups that are investing heavily in R&D but are not yet profitable.

6. Additional Considerations (Often Missed)

6.1. Foreign Research Exclusion

Only research performed within the United States qualifies for the R&D credit. Foreign wages and foreign contract research are excluded.

6.2. Keep Proper Documentation

Taxpayers should maintain:

  • Project descriptions tied to the four-part test
  • Technical uncertainty and experimentation narratives
  • Employee role descriptions and wage allocation methodology
  • Supporting invoices and contracts

The IRS places increasing emphasis on technical substantiation, not just cost schedules.

Tax laws are complex. Consult a CPA or tax advisor for personalized guidance. At Bing Luo CPA, we are committed to providing expert guidance to help you make well-informed decisions.