R&D Tax Credits: The Innovation Incentive Most Businesses Don't Know They Qualify For

When you hear "research and development," you probably picture scientists in white lab coats or engineers in high-tech facilities. That mental image causes countless business owners to overlook one of the most valuable tax credits available—one they may already qualify for based on work they're doing every day.

 

The R&D tax credit isn't reserved for Fortune 500 companies with dedicated research departments. Manufacturers improving production processes, software developers solving technical problems, contractors developing new construction methods, and even breweries perfecting recipes may all qualify. If your business has ever asked "how can we make this work better?" and then experimented to find the answer, you might be leaving significant tax savings on the table.

 

What Is the R&D Tax Credit?

The Research and Development Tax Credit, established under Internal Revenue Code Section 41, provides a dollar-for-dollar reduction in tax liability for businesses that invest in developing new or improved products, processes, software, techniques, or formulas. Unlike a tax deduction that merely reduces taxable income, a tax credit directly reduces your tax bill. A $50,000 R&D credit means $50,000 less in taxes owed—that's real money back in your business.

 

The credit is designed to incentivize American companies to innovate domestically. Congress made the credit permanent in 2015 through the PATH Act, signaling its commitment to supporting business innovation. Combined with recent changes from the One Big Beautiful Bill Act (OBBBA) signed in July 2025—which restored immediate expensing for domestic R&D costs—there's never been a better time to explore whether your business qualifies.

 

The Four-Part Test: How the IRS Defines Qualifying Research

Not every business expense related to improving your operations qualifies for the R&D credit. The IRS applies a four-part test to determine whether activities constitute "qualified research." Your work must satisfy all four criteria.

1. Permitted Purpose: The activity must relate to developing a new or improved business component—meaning a product, process, technique, formula, invention, or software. The improvement must address function, performance, reliability, or quality. Importantly, you don't need to create something entirely new to the world—improvement to how

2. Technological in Nature: The research must fundamentally rely on principles of physical sciences, biological sciences, engineering, or computer science. This eliminates activities based on social sciences, economics, business management, or purely aesthetic changes. However, the bar is lower than many expect—you don't need breakthrough scientific discoveries, just systematic application of technical principles.

3. Elimination of Uncertainty: You must have faced genuine uncertainty about capability (can we do this?), method (how should we do this?), or appropriate design (what's the best approach?). This uncertainty must have existed at the outset of the project. If the answer was known or readily available through standard industry resources, the activity doesn't qualify.

4. Process of Experimentation: You must have evaluated alternatives through a systematic process—testing, modeling, simulation, or trial and error—to eliminate the uncertainty. Simply implementing a known solution doesn't qualify; you need to have experimented to discover the solution.

What Expenses Qualify?

Once you've identified qualifying research activities, the next step is calculating your Qualified Research Expenses (QREs). These fall into four main categories.

• Employee Wages represent the largest category for most businesses. Wages for employees directly performing qualified research, as well as those directly supervising or supporting the research, can be included. If an employee spends substantially all (80% or more) of their time on qualifying activities, their entire wages qualify. For employees with split responsibilities, you must allocate based on time actually spent on qualifying work.
• Supplies include tangible materials consumed in the research process—prototyping materials, testing supplies, components used in experiments, and similar items. This excludes land, improvements to land, and depreciable property.
• Contract Research covers amounts paid to third parties for qualified research conducted on your behalf. However, only 65% of these payments qualify, a statutory reduction from the 100% inclusion for internal expenses.
• Cloud Computing and Computer Rental costs directly associated with qualified research activities also qualify—but only the portion allocable to qualified research. General hosting, production environments, and customer-facing infrastructure don't count. This distinction has become increasingly important as more businesses rely on cloud infrastructure for development, testing, and data processing.

A Closer Look at Contract Research: When Third-Party Work Qualifies

Many businesses outsource development work—hiring a software firm to build a custom application, contracting with an engineering company for product design, or bringing in specialized consultants for technical projects. These payments can qualify for the R&D credit, but the rules are stricter than for internal wages.

 

The 65% Limitation

Unlike employee wages that count dollar-for-dollar, only 65% of contract research payments contribute to your Qualified Research Expenses. A $100,000 software development contract adds only $65,000 to your QREs. This statutory reduction applies to all qualifying contract research. If the research is performed by a qualified research consortium (a tax-exempt organization conducting scientific research), the inclusion rate increases to 75%.

 

You Must Retain Substantial Rights

To claim the credit, you must maintain substantial rights to the research results—though not necessarily exclusive rights. If you're paying a developer to build custom software that you'll own and use in your business, this requirement is typically satisfied. However, if the contractor retains all intellectual property and merely licenses the finished product to you, the arrangement looks more like a purchase than research conducted on your behalf.

 

You Must Bear the Economic Risk

This requirement trips up many businesses. Your payment cannot be contingent on the research succeeding. If your contract states "we'll pay $75,000 upon delivery of working software," the IRS views that as paying for a product , not paying for research —because the contractor bears the risk of failure in that arrangement.

 

The disqualifying factor isn't fixed-price contracts per se—it's payment contingent on success. A fixed-price contract where you're obligated to pay regardless of outcome can still qualify. But in practice, most fixed-price deliverable contracts tie payment to successful completion, which is why time-and-materials contracts and hourly billing arrangements more easily satisfy this requirement. The key question: if the project fails completely, are you still obligated to pay for the work performed? If yes, the expenses can qualify. If no, they likely cannot.

 

The Research Must Still Meet the Four-Part Test

Outsourcing the work doesn't change the fundamental requirements. The development activities must still involve technological uncertainty, a process of experimentation, and the other elements of the four-part test. Routine implementation of known solutions by a contractor doesn't qualify any more than it would if performed internally.

 

U.S.-Based Work Only

The contractor's work must be performed within the United States (including Puerto Rico and U.S. territories). If you hire an offshore development team, those payments don't qualify—regardless of where your company is located or where the contract is signed.

 

Written Agreement Best Practices

While not strictly required, a written agreement entered into before the research begins strengthens your position. The agreement should specify that research will be performed on your behalf, that you retain rights to the results, and ideally should structure payment in a way that doesn't make it contingent on successful completion.

 

Practical Example

Your company hires a U.S.-based software development firm to build a custom inventory management system. The contract is structured as time-and-materials at $150/hour, with weekly invoicing regardless of project status. You retain ownership of all code produced. The developers face genuine technical uncertainty about how to integrate with your legacy systems and experiment with multiple approaches before finding a solution.

 

In this scenario, the payments likely qualify as contract research expenses. You'd include 65% of the total paid in your QRE calculation. If the project costs $200,000, that contributes $130,000 toward your credit calculation.

 

Who Actually Qualifies? Common Industries and Activities

The R&D credit extends far beyond traditional research labs. Here are industries where we frequently identify qualifying activities:

• Manufacturing: Developing new products, improving production efficiency, creating custom tooling, automating processes, reducing defects, and adapting products for new applications.
• Software Development: Creating new applications, developing algorithms, building system integrations, improving performance or security, and automating workflows. Note that routine maintenance and minor updates typically don't qualify—there must be genuine technical uncertainty at the project's outset.
• Construction and Engineering: Developing innovative building methods, improving structural designs, creating solutions for challenging site conditions, and integrating new materials or systems.
• Food and Beverage: Formulating new products, extending shelf life, improving nutritional profiles, scaling recipes for commercial production, and developing new packaging solutions.
• Architecture and Design: Solving structural challenges, developing energy-efficient designs, creating new building systems, and engineering complex installations.
• Agriculture: Developing improved growing techniques, creating pest-resistant solutions, optimizing irrigation systems, and formulating specialized feeds or fertilizers.

How Is the Credit Calculated?

The IRS offers two calculation methods, and businesses should calculate both to determine which provides the greater benefit.

• The Alternative Simplified Credit (ASC) is the more straightforward approach. You calculate your average QREs for the prior three years, multiply by 50%, then subtract that amount from your current year's QREs. The credit equals 14% of this difference. If you have no QREs in any of the prior three years, the credit is simply 6% of current year QREs.
• The Regular Research Credit (RRC) method can produce a larger credit—typically around 10 cents per dollar of QREs versus 6-8 cents for ASC—but requires more complex calculations using historical data going back to the 1980s or, for newer companies, a gradually increasing base percentage over the first five years. This method works well for startups, companies with low historical R&D spending relative to current activities, or companies able to substantiate a favorable base period with adequate records.

The credit rates may seem modest, but they compound significantly when you're investing substantial amounts in innovation. A manufacturer spending $500,000 annually on qualifying activities might generate $35,000-$50,000 in federal credits alone—every single year.

 

Special Benefits for Startups and Small Businesses

The Protecting Americans from Tax Hikes (PATH) Act of 2015 created a particularly valuable option for qualifying small businesses (QSBs). If your company has gross receipts under $5 million for the current year and is within its first five years of having gross receipts, you can elect to apply up to $500,000 in R&D credits against your payroll taxes rather than income taxes.

 

This is transformative for startups that are investing heavily in development but aren't yet profitable enough to owe income tax. Instead of carrying forward unused credits indefinitely, you can immediately reduce your quarterly payroll tax deposits. The credit offsets the employer portion of Social Security tax (up to $250,000) and Medicare tax (up to $250,000), providing real cash flow benefits even when you have no income tax liability.

 

Section 174 Changes: The OBBBA Game-Changer

The tax treatment of R&D expenses has been on a rollercoaster ride. The 2017 Tax Cuts and Jobs Act required businesses to capitalize and amortize domestic R&D costs over five years beginning in 2022—a dramatic change from immediate deductibility. This created cash flow challenges for R&D-intensive businesses.

 

The One Big Beautiful Bill Act (OBBBA), signed July 4, 2025, reversed course by restoring immediate expensing for domestic R&D expenditures going forward. Even better, eligible small businesses (generally those with average annual gross receipts under $31 million over the prior three years) can elect to apply the new expensing rules retroactively to tax years 2022-2024, subject to IRS guidance and procedural requirements—potentially unlocking refunds for previously capitalized expenses.

 

This means you can now claim both the R&D tax credit and immediately deduct your qualifying R&D expenses—maximizing the tax benefit of your innovation investments.

 

Arizona's Generous State R&D Credit

Beyond the federal credit, Arizona offers one of the most generous state R&D incentives in the country. Like the federal credit, Arizona's credit is calculated on incremental research spending—the excess of your current year qualified research expenses over a calculated base amount. The credit rate is 24% on the first $2.5 million of that excess, plus 15% on amounts exceeding $2.5 million (through 2030, with rates dropping to 20%/11% thereafter).

 

One important distinction: Arizona requires use of the federal Regular Credit method for calculating the base amount. You cannot use the Alternative Simplified Credit method for Arizona purposes, even if that's what you use federally.

 

What makes Arizona's program particularly attractive is the refundable component. Companies with fewer than 150 full-time employees can apply to the Arizona Commerce Authority for a partial refund of up to 75% of their excess credit amount—meaning you may receive cash back even if your Arizona tax liability is zero. However, refunds are subject to annual program caps, allocated on a first-come first-served basis, and individual refunds are capped at $100,000 per taxpayer annually. The overall program cap fills quickly, so timing your application on the first business day of the calendar year is critical. Unused credits can be carried forward for 10 years (for credits earned in tax years beginning after December 31, 2021).

Arizona leverages the federal IRC Section 41 rules for determining qualified activities, so if you qualify for the federal credit, you likely qualify for Arizona's credit as well. Companies making qualified basic research payments to Arizona State University, Northern Arizona University, or the University of Arizona may qualify for an additional 10% credit on those payments above their base amount.

 

Documentation: The Key to Surviving IRS Scrutiny

The IRS has significantly increased its focus on R&D credit claims in recent years, and documentation is your first line of defense. The new Form 6765 requirements (mandatory for 2026, optional for 2025) require detailed project-level reporting for businesses with significant QREs.

Maintain contemporaneous records that demonstrate:

• Project descriptions explaining what you were trying to develop or improve
• Technical uncertainty that existed at the project's outset
• Process of experimentation you followed to resolve uncertainties
• Time records showing which employees worked on qualifying activities and for how long
• Expense allocation connecting costs to specific qualifying projects
• Outcomes(both successful and unsuccessful—failed experiments still qualify)

The IRS explicitly warns that job titles alone don't determine qualification—what matters is what employees actually did during specific time periods. Building a documentation habit now will protect your credits if questions arise later.

 

Common Misconceptions That Cost Business Owners Money

• "We don't have an R&D department." The credit isn't limited to formal R&D departments. Activities performed by engineers, developers, production staff, and technical personnel throughout your organization may qualify.
• "We didn't invent anything new." You don't need patentable inventions or industry-first discoveries. Improving your own products or processes counts, even if competitors have developed similar solutions independently.
• "Our projects failed." The credit rewards the research process, not successful outcomes. Activities that don't pan out still qualify if they met the four-part test at the time they were undertaken.
• "We're too small." There's no minimum company size. Small businesses often have higher QRE-to-revenue ratios than large corporations, making the credit proportionally more valuable.
• "It's not worth the hassle." A properly documented R&D credit study typically generates credits worth 6-10 cents per dollar of qualifying expenses annually—often tens of thousands of dollars for even modestly-sized operations. The federal credit can be carried forward for 20 years if you can't use it immediately (state carryforward periods vary).

Taking the Next Step

Identifying and documenting R&D activities requires careful analysis of your operations against IRS requirements. The calculations involve nuanced decisions about which method produces the best result, and the documentation requirements have become increasingly rigorous. Getting professional guidance upfront helps maximize your credit while building the records needed to withstand examination.

 

At Desert Rose Tax & Accounting, we help businesses identify qualifying R&D activities they may have overlooked, calculate credits using both methods to determine the optimal approach, build documentation systems that satisfy IRS requirements, coordinate federal and Arizona state credit claims, and evaluate whether retroactive elections under OBBBA make sense for your situation.

If your business invests in innovation—whether developing new products, improving processes, creating software, or solving technical challenges—you may be leaving significant tax savings unclaimed. Let's find out what you're missing.

 

Contact Desert Rose Tax & Accounting at (520) 747-4964 or visit www.desertrosetax.com to schedule a consultation and explore whether R&D credits can reduce your tax burden.

 

Edward Ethington, CPA, CFP®, MBA
Desert Rose Tax & Accounting
Helping Arizona Businesses Invest in Innovation
(520) 747-4964
www.desertrosetax.com

 

This blog provides general information about R&D tax credits and should not be construed as personal tax advice. R&D credit qualification involves complex technical and legal determinations that depend on your specific facts and circumstances. Tax laws change frequently—the OBBBA provisions discussed were enacted in July 2025. Please consult with qualified tax professionals at Desert Rose Tax & Accounting before claiming R&D credits or making tax elections.