The federal research and development (R&D) tax credit provides businesses an opportunity to reduce their tax liability based on their research-related expenses. But which expenses can you include when you calculate the credit? Here’s what you need to know.
What is the R&D credit?
The R&D credit, also known as the Credit for Increasing Research Activities or the Sec. 41 credit (its formal name under Internal Revenue Code Section 41), generally allows a business doing “qualified research” to apply a percentage of its qualified expenses to offset, on a dollar-for-dollar basis, its federal income tax or payroll tax liability. It was established to encourage domestic businesses to conduct R&D work in the United States.
There’s no limit on the amount of credit you can claim each tax year to offset income tax liabilities. However, limitations on the amount of general business credits that may be used each year do apply. You can carry unused credits forward for 20 years or back one year to offset tax liability in those years.
You also can apply some or all of the credit against your payroll tax liability. This allows businesses to benefit from the credit by claiming employee wages as qualified R&D tax credit expenses, since they may not have yet incurred income tax liability. For payroll tax, the limit is $500,000 each tax year, split into up to $250,000 against the employer's share of Social Security tax and up to $250,000 against the employer's share of Medicare tax.
Which expenses qualify for the R&D tax credit?
R&D tax credit qualified expenses fall into two categories: basic research payments (BRPs) and qualified research expenses (QREs). Basic research is an original investigation to gain scientific knowledge, without a specific commercial objective, performed by a qualified organization. (For example, a university or scientific research organization.)
Most businesses base their R&D credits on QREs. QREs encompass:
In-house research expenses—generally, wages for qualified services, the cost of supplies, and rental costs for computers
Contract research expenses (see below for more information).
In contrast to BRPs, QREs don’t need to be for original investigations but must be for specific commercial objectives.
What are “contract research expenses”?
Contract research expenses refer to your expenses for time that third parties, who aren’t part of your business, spend conducting or executing qualified research.
Questions can sometimes arise about who can claim the credit: the business or the contractor. To get the credit, you must maintain substantial rights (not necessarily exclusive) to the research performed and bear the financial risk of failure.
The latter requirement means your business must pay the contractor regardless of whether the research is successful. If payment is contingent on success, it’s deemed to be for the product or result, rather than research.
Note: You can’t include prepaid contract research expenses in your QREs until the research is actually performed.
What counts as supplies and materials?
The term “supplies” generally refers to the cost of materials used in qualified research. The IRS defines it as any tangible property (other than land and improvements) used in the R&D process that you haven’t depreciated. It includes, for example, component parts, tools, molds, dyes, reagents, chemicals, and other raw materials—the materials you might use when building and testing prototypes.
These types of supplies don’t count as R&D tax credit qualified expenses:
Depreciable equipment
General office supplies
Travel, rental expenses, or meals
Overhead
License fees
Asset rental costs
Supplies usually account for a relatively small portion of total QREs. If they represent a significant amount, it could be a red flag for the IRS that your QREs include ineligible expenses.
Does my company’s research qualify for the credit?
The credit generally is available to any business that works to develop new products or processes—even if the research ultimately fails to produce the desired results. Many eligible taxpayers don’t claim the credit, though, likely due to misunderstandings about the kinds of research that qualify.
The IRS has a four-part test for qualified research activities. Your research may qualify if it satisfies all of the following criteria:
It’s performed to eliminate technical uncertainty about the development or improvement of a product or process, including computer software, techniques, formulas, and inventions. The research needs to be about more than making mere cosmetic changes.
It’s undertaken to discover information that’s “technological” in nature. This doesn’t mean it must be about technology, technological products, or processes. It’s generally sufficient if the research employs physical, biological, engineering, or computer science principles.
It’s intended for use in developing a new or improved business product or process. That could translate to improvements in accuracy, quality, speed, or other performance measures.
Substantially all (generally, at least 80 percent) of the research activities are elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality. “Experimentation” typically involves trial and error while determining the best route.
What types of activities don’t count as qualified research?
You can’t claim the R&D credit for expenses related to:
General administration
Research conducted after commercial production of the product or process has begun
Research adapting an existing product or process to a particular customer’s need
Duplication of an existing product or process (in whole or part)
Surveys or studies, including:
Efficiency studies
Activities related to management function or technique
Market research, testing, or development
Routine data collection
Routine quality control testing or inspection
Research relating to certain internal-use computer software
Research conducted outside the United States, Puerto Rico, or a U.S. possession
Research in the social sciences, arts, or humanities
Research funded by another person or governmental entity
Which compensation costs are included as wages?
For purposes of the R&D tax credit, wages include all taxable wages paid to employees who perform “qualified services,” defined as:
Engaging in qualified research (for example, a scientist conducting lab experiments),
Directly supervising qualified research (for example, a first-line research scientist who directly supervises lab experiments but might not actually perform experiments), or
Directly supporting qualified research (for example, a machinist who fabricates part of an experimental model).
Direct support doesn’t include general and administrative services that only indirectly benefit research activities.
Taxable wages include bonuses and stock option redemptions. They don’t include amounts not subject to withholding (for example, certain fringe benefits).
Note: You can't count the same wages toward two credits. Wages used to claim the Work Opportunity Tax Credit (WOTC) can't also be counted as QREs for the R&D credit, though note that WOTC authorization lapsed for employees hired after December 31, 2025 and awaits possible renewal by Congress.
How much of an employee’s wages can I include in my QREs?
Generally, you can include only wages for time attributable to qualified services performed by the employee. But there is an exception that allows you to include wages for time not clearly attributable to those activities.
If substantially all of an employee’s work consists of qualified services, you can include the wages for all of the services performed by that employee — qualified or not. In other words, if at least 80 percent of an employee’s hours are spent on qualified services, you can include 100 percent of their wages. If less than 80 percent of their hours are spent on qualified services, though, you can use only the actual hours spent on such services.
Note: You’ll need solid documentation of the wages you include as QREs. The IRS will look for information such as payroll records, job descriptions, performance evaluations, and calendars to determine the services performed and the time spent doing it. The focus is on the actual work performed, rather than a job description or title. Beyond the records you keep, the way you report those expenses on the form itself has also changed: for tax years beginning after 2025, most taxpayers must complete Section G of the redesigned Form 6765, which requires reporting qualified research expenses by business component (the specific product, process, or software being developed), with wages split into direct research, direct supervision, and direct support.
Is there a limit on the amount of contract research expenses I can include in my QREs?
Yes. You can include 65 percent of any amount paid or incurred to a third party for qualified research.
If the research is performed by a qualified research consortium, you can claim 75 percent of the expenses. Research consortiums are generally tax-exempt and organized and operated to conduct scientific research.
Which computer costs are QREs?
You can include your rental costs for computers used in R&D tax credit qualified activities, including cloud computing used to perform research.
Do all of my research and experimental (R&E) deduction expenses automatically count as QREs?
No. QREs for the R&D credit must first qualify as research and experimental (R&E) expenditures. For domestic research, those costs are again immediately deductible under Section 174A, which the One Big Beautiful Bill Act of 2025 enacted to restore immediate expensing for tax years beginning after December 31, 2024. (From 2022 through 2024, R&E costs had to be capitalized and amortized, and foreign research must still be amortized over 15 years.) But qualifying as an R&E expenditure is only one part of the four-part test (the first part). Sec. 41 imposes additional requirements that don't have to be met to claim the R&E deduction.
So while every QRE is necessarily an R&E (Section 174/174A), the opposite isn't true. R&E expenses include certain indirect research costs that aren't QREs for the R&D credit, such as facilities and depreciation.
Frequently Asked Questions
Do software development costs qualify for the R&D tax credit?
Yes — software development can qualify when it meets the IRS four-part test, such as resolving technical uncertainty through experimentation. Wages for developers, plus related supplies and cloud-computing costs, may count as QREs. Software built primarily for internal general and administrative use faces a higher bar (the high-threshold-of-innovation test under Treas. Reg. §1.41-4(c)(6)) and often doesn't qualify.
Can startups claim the R&D tax credit for qualified expenses?
Yes. Even without income tax liability, a qualified small business can apply up to $500,000 of the R&D credit against payroll taxes each year. To qualify, you generally need less than $5 million in current-year gross receipts and no gross receipts dating back more than five years.
How do state R&D tax credits differ from the federal R&D credit?
State R&D tax credits vary widely. Most states with an income tax also offer their own R&D credit, and because these credits operate independently, they can often be claimed alongside the federal credit. Rates, refundability, eligibility rules, and carryforward periods differ by state. Many follow the federal definition of qualified expenses, while states like California and Connecticut apply their own rules.
Can outsourcing certain research tasks to foreign contractors qualify for the credit?
Generally, no. Research must be performed within the United States, Puerto Rico, or a U.S. possession, so work done by foreign contractors abroad doesn't qualify. Even for qualifying domestic contract research, you can include only 65% of the amount paid, or 75% for payments to a qualified research consortium.
How do I document and substantiate my QREs for an IRS audit?
Document the work as it happens, so you don’t have to reconstruct it for an audit. Keep records tying wages to qualified work: payroll records, job descriptions, performance reviews, and project notes or calendars. The IRS focuses on the actual work performed, not job titles. For tax years beginning after 2025, most filers must also report QREs by business component on Section G of Form 6765.
Are training costs for employees involved in R&D activities eligible for the credit?
Training costs are usually ineligible for the R&D credit. Qualified wages cover employees who engage in, directly supervise, or directly support qualified research — not time spent being trained. Employee education and training costs fall outside qualified research expenses. Wages become eligible only once the employee is actually performing research that meets the four-part test.
Can Gusto help?
Yep! Gusto can identify eligible Research & Development tax credits. Check out our tax credit page to learn more.
