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R&D Tax Credit: Is Your Company Leaving Money on the Table?

Research and development is often associated with laboratories, pharmaceutical companies, engineers, and technology startups. But the federal Research and Development (R&D) Tax Credit is much broader than many business owners realize.

A company does not necessarily need to have a formal research department, scientists in white coats, or a product labeled “R&D” to potentially qualify.

Businesses may conduct qualifying research while:

The important question is not simply whether a company calls something “research and development.”

The question is whether the underlying activities and expenses satisfy the requirements of Internal Revenue Code Section 41.

For companies investing significant resources in development, the R&D tax credit can represent a valuable tax-planning opportunity. At the same time, claiming the credit requires careful documentation and a defensible analysis of qualifying activities and expenses.

At Velin & Associates, Inc., we help businesses evaluate potential tax opportunities and develop tax strategies based on their actual operations—not simply their industry classification.

What Is the R&D Tax Credit?

The federal R&D Tax Credit, formally known as the Credit for Increasing Research Activities, is a tax credit available to eligible businesses that incur qualified research expenses.

Unlike a tax deduction, which generally reduces taxable income, a tax credit directly reduces tax liability.

That distinction can make the R&D credit particularly valuable.

The IRS describes qualified research expenses as generally consisting of in-house research expenses and contract research expenses.

The credit is generally calculated under Section 41 based on qualified research expenses and the applicable credit methodology.

However, simply spending money on product development does not automatically create a credit.

The underlying research activities must meet the statutory requirements.

Why Companies Miss the R&D Credit

One of the biggest problems is that business owners often define R&D too narrowly.

A company might say:

“We don’t have an R&D department.”

That does not necessarily mean the company has no qualifying research.

Another business might say:

“We’re a manufacturing company, not a technology company.”

Again, that does not answer the tax question.

A manufacturing company may spend substantial amounts developing new products, improving production processes, testing materials, or resolving technical uncertainties.

A software company may spend substantial amounts developing new functionality.

An engineering company may conduct experimentation for clients or for its own projects.

A medical technology company may develop and test new systems or components.

The tax analysis focuses on what the company actually did, not simply the title of the department or the industry listed on the company’s business license.

The Four-Part Test for Qualified Research

The IRS generally requires qualified research to satisfy several requirements.

Under Section 41, qualified research generally must involve:

  1. An effort to discover technological information
  2. An intended application of that information to develop or improve a business component
  3. A process of experimentation
  4. A permitted purpose such as improving function, performance, reliability, or quality

The IRS’s current Form 6765 instructions describe these requirements in more detail.

Let’s break this down into practical terms.

1. There Must Be a Technological Basis

The research generally needs to rely on principles of the physical or biological sciences, engineering, or computer science.

This can include areas such as:

Example: A manufacturer is developing a new component. The engineering team must determine how different materials, dimensions, tolerances, and manufacturing techniques affect the component’s performance. The team uses engineering principles and testing to determine which design works.

That may be relevant to the R&D credit analysis.

2. The Research Must Relate to a Business Component

The research generally must be undertaken to develop or improve a business component.

A business component can include products, processes, software, techniques, formulas, or inventions used by the taxpayer in its business.

Example: A company is developing a new software platform. The company is uncertain how to build a particular data-processing feature while meeting performance requirements. Developers test multiple approaches and eventually create a workable solution.

The development activities may potentially qualify if the other requirements are satisfied.

3. There Must Be a Process of Experimentation

This is one of the most important parts of the analysis.

The company generally needs to evaluate alternatives through experimentation rather than simply implementing a known solution.

This could involve:

Example: A manufacturer wants to reduce the weight of a product without sacrificing strength. The engineering team considers several materials and designs. The company produces prototypes, performs stress testing, evaluates the results, modifies the design, and conducts additional testing.

That iterative process may contain qualifying research activities.

4. The Research Must Have a Permitted Purpose

The research generally needs to relate to improving a business component’s:

The objective does not necessarily have to be creating something completely revolutionary.

Improving an existing product or process can potentially qualify.

Example: A software company already has a functioning application. The company decides to redesign the application’s architecture because the existing system cannot process the volume of transactions required by its growing customer base. Developers evaluate multiple technical approaches and conduct performance testing.

The research may potentially qualify even though the company already had an existing product.

R&D Does Not Have to Mean Inventing Something Completely New

This is one of the most common misconceptions.

A company does not necessarily need to invent a completely new product for research to qualify.

Research can involve improving an existing business component.

Example: A manufacturer produces an existing product. Customers want the product to operate at higher temperatures. The company must determine whether different materials, components, or manufacturing methods can achieve the required performance. The company performs testing and experimentation.

The project may potentially qualify even though the underlying product already exists.

Which Expenses Can Potentially Qualify?

Once qualifying research activities have been identified, the next question is the expenses associated with those activities.

Qualified research expenses generally include certain:

The IRS specifically identifies wages for employees performing qualified services and supplies used in qualified research as components of in-house research expenses.

The actual calculation can be more complicated, and not every expense associated with an R&D project automatically qualifies.

Employee Wages

Employee compensation can be one of the largest components of an R&D credit calculation.

Potentially qualifying wages can include compensation for employees performing qualified research services.

This could include:

Example: A company has five software developers. They spend approximately 60% of their working time developing and testing new software functionality and 40% maintaining existing systems. The company should not automatically treat 100% of their wages as qualified research expenses. Instead, it should evaluate the employees’ actual activities and determine what portion relates to qualifying research.

This is why time records, project records, development documentation, and other supporting information can be extremely valuable.

Supplies

Certain supplies used in conducting qualified research may also be included.

For example, a manufacturer conducting experimentation may use:

Example: A manufacturing company spends $120,000 on materials used specifically to create and test prototypes for a new product. The company should determine which portion of those expenses meets the statutory requirements for qualified supplies.

Not every material purchased by the company becomes a qualified research expense merely because the company has an R&D project.

Contract Research

Companies may also use outside contractors for research activities.

Certain contract research expenses may potentially qualify, subject to specific statutory requirements and limitations.

Example: A technology company hires an outside engineering firm to conduct specialized testing for a new product.

The company should examine:

The contract itself can be important supporting documentation.

Software Development and the R&D Credit

Software development is one of the areas where companies frequently overlook potential R&D opportunities.

Software businesses may conduct qualifying research while developing:

However, not every software development project qualifies.

The rules contain additional requirements, particularly for software developed primarily for internal use.

The IRS states that internal-use software generally must satisfy the qualified research requirements and a higher threshold of innovation test.

Example: Software Company

A software company wants to create a platform capable of processing millions of transactions simultaneously.

The developers do not know which architecture will provide the required speed and reliability.

They:

  1. Evaluate several architectures
  2. Build prototypes
  3. Test processing speeds
  4. Identify performance limitations
  5. Modify the architecture
  6. Conduct additional testing
  7. Eventually implement the successful solution

The wages and other qualifying expenses associated with the research may potentially be included in an R&D credit calculation. The company does not need to label the project “R&D” for the activities to potentially qualify.

Example: Manufacturing Company

A manufacturer wants to develop a lighter product that maintains the strength of its existing product.

The engineering team tests:

Several prototypes fail testing. The team modifies the design and conducts additional tests until it reaches the desired performance. This type of iterative technical development is exactly the kind of activity that deserves an R&D credit review.

Example: Medical Device Company

A company develops a medical device component. The team needs to determine whether a particular design will meet performance requirements while remaining commercially practical. The company develops several prototypes, conducts testing, analyzes failures, and modifies the design.

The company may have potentially qualifying research expenses associated with:

The final determination depends on the specific facts and statutory requirements.

Example: Architecture and Engineering Firm

An engineering firm works on complex projects requiring new technical solutions. For a particular project, the firm must determine how to achieve a required structural performance level under unusual conditions. The engineers evaluate several technical alternatives and perform modeling and testing.

Depending on the facts, some of the firm’s activities and expenses may potentially qualify. However, simply performing engineering work does not automatically make the entire project eligible. The activities must satisfy the Section 41 requirements.

Example: Creative or Media Technology Company

A media company develops a proprietary platform for processing and delivering large video files. The company’s developers face uncertainty about how to reduce processing time while maintaining quality. They test different compression approaches, data architectures, and processing methods. This may create an opportunity for an R&D credit analysis. The company does not have to be a traditional “technology company” for the research credit to potentially apply.

The Difference Between R&D Expenses and the R&D Tax Credit

This distinction is particularly important.

A company may have research and experimental expenditures for purposes of Section 174A and separately have qualified research expenses for purposes of the Section 41 credit.

These concepts overlap but are not identical.

The tax treatment of research and experimental expenditures also changed significantly under legislation enacted in 2025.

For tax years beginning after December 31, 2024, Section 174A generally allows taxpayers to deduct domestic research or experimental expenditures currently, with certain alternative capitalization and amortization elections available. Foreign research continues to be subject to different treatment.

That means companies should not assume that their accounting treatment automatically determines their R&D credit eligibility.

The 2025 Changes Make R&D Tax Planning Even More Important

Recent changes to the tax treatment of research and experimental expenditures have made R&D tax planning more complicated—and potentially more valuable.

For domestic research or experimental expenditures incurred after 2024, taxpayers generally have the option to deduct qualifying domestic expenditures currently under Section 174A or elect certain capitalization and amortization treatment.

Meanwhile, foreign research generally continues to be amortized over 15 years under the amended Section 174 rules.

This means a company may need to analyze two separate questions:

Question 1:

How should the company’s research and experimental expenditures be treated for income tax purposes?

Question 2:

Do the company’s activities and expenses qualify for the Section 41 R&D credit?

These should not be treated as the same question.

Domestic vs. Foreign Research

Location matters.

The current tax rules distinguish between domestic and foreign research.

Foreign research generally refers to research conducted outside the United States, Puerto Rico, or a U.S. territory. Certain foreign research expenditures remain subject to the Section 174 capitalization and 15-year amortization rules.

Example: A U.S. technology company has developers in California and a development team in another country. The company should not automatically treat all development expenses the same for tax purposes. The location where the research activities are actually performed can affect the tax treatment.

This is especially important for companies using international development teams or contractors.

The R&D Credit Is Not Just for Large Corporations

Small and mid-sized businesses can potentially benefit as well.

A company does not necessarily need millions of dollars in research expenses.

For example, a growing company might have:

Over several years, those expenses can become significant.

Example: A growing software company has $600,000 of potentially qualified employee wages associated with qualifying development activities. Even a relatively modest credit percentage could create a meaningful tax benefit.

The actual credit cannot be estimated simply by multiplying total R&D spending by a fixed percentage because the Section 41 calculation involves specific rules and methodologies. That is why a proper credit study matters.

Startups May Have Additional Planning Opportunities

Certain eligible small businesses may be able to use the research credit against payroll taxes rather than waiting until they generate income tax liability.

The rules have specific eligibility requirements and limitations.

For a startup that is investing heavily in development but has little or no taxable income, this can be an important planning consideration.

Example: A startup spends heavily developing proprietary software but operates at a tax loss during its early years. The company may not have enough regular income tax liability to immediately use the entire research credit. Depending on its circumstances and eligibility, it may be able to elect to apply a portion of the credit against certain payroll taxes.

This should be evaluated as part of the overall tax strategy.

Documentation Is Critical

One of the most important aspects of an R&D credit claim is documentation.

A company should be able to explain:

What was developed?

What uncertainty existed?

What alternatives were considered?

What experimentation occurred?

Who performed the work?

What expenses were associated with the qualifying activities?

The IRS specifically requires detailed information for certain research credit claims, including identification of business components, research activities, and qualified employee wage, supply, and contract research expenses.

What Documentation Should a Company Keep?

Useful documentation can include:

Project documentation

Software documentation

Testing documentation

Financial documentation

Employee documentation

The goal is not to create paperwork simply for the sake of paperwork.

The goal is to establish a clear connection between:

qualifying research → business component → research activities → qualified expenses

A Common Mistake: Looking Only at the General Ledger

A general ledger might show:

Engineering Payroll — $1,200,000

That number alone does not tell you how much potentially qualifies.

The accounting records need to be connected to the actual activities performed.

Example: An engineering department has 10 employees Some spend most of their time on qualifying product development.

Others primarily perform:

The entire $1.2 million payroll should not automatically be treated as qualified research expense. The analysis needs to identify the portion attributable to qualifying activities.

Another Common Mistake: Assuming Every New Product Qualifies

A company may develop a new product without conducting qualified research.

For example, suppose a company purchases an existing product design from another company and simply manufactures it.

There may be no technological uncertainty or experimentation performed by the taxpayer.

That is very different from developing a product where the company must resolve technical uncertainty through experimentation.

The fact that a product is “new to the company” does not automatically mean the research qualifies.

Another Mistake: Claiming 100% of a Project

R&D projects frequently contain both qualifying and non-qualifying activities.

Example: A company develops a new software product.

The project includes:

Some activities may qualify. Others may not. A strong R&D study separates the qualifying activities instead of simply treating the entire project as eligible.

Can a Company Claim the Credit for Previous Years?

Potentially, yes.

Businesses that discover they may have been eligible for the credit in prior years should discuss whether amended returns or other procedures are appropriate.

However, the IRS has specific substantiation requirements for amended research credit claims.

For example, the IRS currently requires taxpayers making certain amended research credit claims to provide detailed information about the business components, research activities, and qualified expenses.

Therefore, a company should not simply submit an amended return containing a new credit number without adequate supporting analysis.

How an R&D Credit Review Can Work

A practical review can begin with a conversation between the tax advisor and company management.

Step 1: Identify Potential Projects

Ask:

Step 2: Identify Technical Uncertainty

Determine whether the company faced uncertainty regarding:

Step 3: Identify Experimentation

Determine whether the company:

Step 4: Identify Employees

Determine which employees actually performed qualifying research activities.

Step 5: Calculate Potential Qualified Expenses

Analyze:

Step 6: Review Documentation

Determine whether the company has enough documentation to support the claim.

Step 7: Calculate the Credit

Apply the appropriate Section 41 methodology and applicable limitations.

Step 8: Coordinate With the Tax Return

The credit calculation needs to be properly reflected on the applicable tax filings.

What Industries Should Consider an R&D Review?

There is no single industry that owns the R&D credit.

Potential opportunities may exist in:

Even companies that do not traditionally describe themselves as “research companies” should consider whether their activities warrant a review.

R&D Credit vs. Ordinary Business Deduction

A company may already deduct certain business expenses.

That does not necessarily mean there is no R&D credit opportunity.

The credit is a separate tax incentive with its own eligibility requirements.

Example: A company pays $500,000 in wages to employees involved in qualifying research. The company may have already included those wages as a business expense. That does not automatically eliminate the possibility of a research credit. However, the interaction between the credit and the deduction must be properly addressed under the applicable tax rules.

For example, Section 280C contains rules affecting the treatment of deductions associated with the research credit, including an election to take a reduced credit instead of reducing certain deductions.

The R&D Credit Should Be Part of Tax Planning—not an Afterthought

One of the biggest mistakes businesses make is waiting until tax return preparation to think about R&D.

By then, important documentation may be missing.

Employees may no longer remember why a particular design decision was made.

Projects may have been completed months earlier.

Contractors may be difficult to reach.

A better approach is to make R&D documentation part of the company’s regular accounting and project-management processes.

Example: A Better Internal Process

A growing company develops several new products every year.

Instead of waiting until tax season, management reviews projects quarterly.

For each potentially qualifying project, the company records:

At year-end, the tax advisor can use this information to perform the credit analysis.

This can be substantially more efficient than attempting to reconstruct the company’s research activities months or years later.

How Much Could Your Company Save?

There is no universal percentage that applies to every business.

The actual benefit depends on factors including:

Therefore, advertisements promising a specific R&D credit amount based solely on total payroll or revenue should be treated cautiously.

A legitimate analysis should be based on the company’s actual qualifying activities and expenses.

Is Your Company Leaving Money on the Table?

The answer may be yes if your company is developing, testing, designing, engineering, or improving products, software, or processes without reviewing those activities for R&D credit eligibility.

You may be overlooking an opportunity if your company:

But eligibility should never be determined solely from the industry name or a list of expenses.

The activities themselves are what matter.

Final Thoughts

The R&D Tax Credit can be a valuable tax-planning tool for companies that invest in innovation, technology, product development, engineering, software, or process improvement.

Yet many businesses overlook the opportunity because they assume R&D means a formal laboratory or a large research department.

In reality, qualifying activities can occur throughout an organization.

A software developer solving a technical problem.

An engineer testing multiple designs.

A manufacturer developing a new production process.

A product team building and testing prototypes.

A technology company experimenting with a new architecture.

These activities may potentially create qualified research expenses—but only when the specific statutory requirements are satisfied.

The recent changes to the tax treatment of domestic research and experimental expenditures also make it increasingly important to distinguish Section 174A tax treatment from the Section 41 research credit. Domestic research expenditures incurred after 2024 can generally receive current deductions under Section 174A, while the separate research credit continues to require its own qualification analysis.

The best time to evaluate an R&D opportunity is before tax season, while project information, employee activities, and supporting documentation are still available.

Could Your Company Qualify for the R&D Tax Credit?

If your business develops products, software, technology, manufacturing processes, or other innovative solutions, Velin & Associates, Inc. can help evaluate whether an R&D tax credit analysis should be part of your overall tax-planning strategy.

A proper review can help identify potential opportunities while also making sure that the claim is supported by the company’s actual activities and documentation.

Tax rules surrounding the R&D credit and research and experimental expenditures are complex and subject to specific eligibility, substantiation, and procedural requirements. This article is for general informational purposes and should not be treated as individualized tax advice.

For more information about our tax planning services, contact us today: our website. 

Velin & Associates, Inc.

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West Hollywood, CA 90046
📞 323-902-1000
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