How to Identify Qualified Research Expenses: A Plain-English Guide [With Examples]
The R&D tax credit reduces your tax bill dollar-for-dollar, making it one of the most important domestic tax credits available under current tax law. Your business could miss this great chance because you might not know which expenses qualify.
Qualified research expenses (QREs) include specific costs you incur when developing or improving products, processes, techniques, formulas, inventions, or software that meet IRS requirements. Your activities’ qualification allows us to evaluate eligible expenses like your employee’s wages for qualified services, research materials, and costs tied to outside research services[-4].
Let us explain what counts as qualified research expenses in this piece. You’ll learn how to spot them in your business through practical examples that help determine your eligibility for this powerful tax benefit. Your understanding of these requirements could boost your competitive edge with five- and six-figure benefits.
What are Qualified Research Expenses?
Qualified research expenses (QREs) are the foundations of calculating your R&D tax credit. You need to know what counts as a QRE to maximize your tax benefits and stay compliant with IRS regulations.
Definition of QREs under IRS Section 41
IRS Section 41(b) defines qualified research expenses as the combination of “in-house research expenses” and “contract research expenses” that you pay while running your business. These expenses must connect directly to research activities that meet the IRS’s four-part qualification test.
In-house research expenses include:
Wages paid to employees performing qualified services
Costs for supplies used in research
Amounts paid for computer rental or cloud computing services used in research activities
Contract research expenses typically include 65% of what you pay outside vendors or contractors who perform qualified research for you.
Why QREs matter for the R&D tax credit
QREs play a vital role because they determine your R&D tax credit amount. The credit usually ranges from six to ten percent of your qualified research expenses. It also provides a dollar-for-dollar reduction of your tax liability, unlike many other tax incentives.
Small businesses can see even bigger benefits. Since 2016, qualified small businesses can apply up to $250,000 of their R&D credits against employer Social Security payroll taxes. Starting in the 2023 tax year, this limit jumped to $500,000 and now covers both employer Social Security and Medicare taxes.
Difference between deductions and credits
Tax credits and deductions support research activities differently:
R&D tax credits cut your tax liability dollar-for-dollar, while deductions only lower your taxable income. This is a big deal as it means that credits offer more value than equal amounts of deductions.
The qualification criteria also differ. The Tax Cuts and Jobs Act (TCJA) changed I.R.C. §174. Now businesses must capitalize and amortize R&D costs over five years instead of deducting them right away. These R&D expenses might not qualify for the R&D tax credit, which has tougher qualification requirements.
Types of Qualified Research Expenses
Understanding which expenses qualify is vital to calculate your R&D tax credit. The IRS recognizes four main categories of qualified research expenses that can affect your tax savings by a lot.
Employee wages for qualified services
Employee wages often represent the largest portion of qualified research expenses for most companies. Taxable wages reported on Form W-2 are included, along with bonuses and stock option redemptions. Employees must perform one of these three services to qualify:
Engaging in qualified research (scientists conducting experiments)
Directly supervising qualified research (first-line management)
Directly supporting qualified research (machinist creating experimental parts)
The IRS applies a “substantially all” rule—employees who spend at least 80% of their time on qualified services can claim 100% of their wages. If not, only the actual time spent on qualified activities counts.
Supplies used in experimentation
Qualified supplies for R&D tax credit has non-depreciable tangible property used directly in research activities. Laboratory supplies, prototype materials, and components used in testing are included.
Your total QREs should have supplies as a relatively small portion. These items are specifically excluded:
Land and improvements
Depreciable property
Non-tangible expenses like rental costs or licensing fees
Contract research expenses
You can claim 65% of amounts paid to third parties for qualified research conducted on your behalf. This percentage goes up to 75% if a qualified research consortium performs the research.
These expenses must pass a three-part test to qualify:
The agreement must exist before research begins
The third party must perform research on your behalf
Your company must bear the financial risk whatever the outcome
Computer rental or cloud computing costs
Computer rental or cloud service expenses qualify when used directly in R&D activities. The IRS has three requirements:
Someone other than you must own and operate the computer
It must be located off your premises
You cannot be the primary user
Cloud computing services naturally meet these requirements. Note that only costs directly related to development environments qualify, not general hosting or storage.
How to Know If Your Research Qualifies
The IRS’s four-part test determines if your research qualifies for the R&D tax credit. Here’s a breakdown of each component in plain English.
1. Business component test
Your research must connect to a specific “business component” – a product, process, software, technique, formula, or invention that you sell, lease, license, or use in your business. You need to improve the functionality, performance, reliability, or quality of that component – not just make esthetic or cosmetic changes.
Clear definition of your business components matters in documentation preparation. The Fifth Circuit case in Grigsby showed that failing this requirement can void the entire credit.
2. Technological in nature
You don’t need lab coats or test tubes to qualify, contrary to popular belief. Your research must rely on principles of physical science, biological science, engineering, or computer science.
Section 41 excludes research in social sciences, arts, humanities, or market research. The IRS named this the “technological in nature” requirement to limit qualification to hard sciences.
3. Elimination of uncertainty
Your research needs to tackle uncertainty about the capability, methodology, or design of your business component. You must show that success wasn’t guaranteed beforehand.
The patent safe harbor provision proves you’ve met this test conclusively—a USPTO-issued patent automatically satisfies three parts of the four-part test.
4. Process of experimentation
You must demonstrate using a systematic approach to assess alternatives. This process needs three core elements:
Identifying the technological uncertainty
Identifying one or more alternatives to address that uncertainty
Conducting a systematic evaluation of those alternatives
This could include iterative testing, trial and error, or scientific method approaches. Note that 80% of your R&D activities must support this experimentation process.
What Doesn’t Count as Qualified Research
Knowing what doesn’t count as research is just as crucial as understanding what does. The IRS won’t allow R&D tax credits for specific activities, whatever their innovation level might seem.
Routine data collection or quality control
Not every technical task qualifies for the R&D credit. Standard testing, basic data collection, and regular quality checks don’t meet the requirements. Basic debugging of existing systems or minor software updates also fall short of the experimentation threshold.
Research done outside the U.S.
Your research location makes a big difference for qualified expenses. The R&D credit applies only to work done in the United States, including Puerto Rico and U.S. territories. You can’t claim any research activities performed in other countries, even if they break new technological ground.
Reverse engineering or duplication
A simple copy of an existing product or process won’t qualify. The IRS rules out any work that involves reverse engineering competitors’ products or copying existing solutions without major improvements.
Social sciences and market research
Research in economics, business management, or consumer behavior has value but doesn’t qualify. Market research, efficiency surveys, and management studies don’t meet the “technological in nature” requirement because they focus on non-scientific areas.
Funded research by grants or contracts
You usually can’t claim credit for research that someone else pays for. Of course, when another entity takes the economic risk or owns substantial rights to research results, those expenses don’t qualify. Government grants often make research ineligible for tax credits.
Conclusion
You need to understand qualified research expenses to get the most from your R&D tax credit benefits. This piece covers everything in QREs – from employee wages and supplies to contract research and computer rental costs. We’ve also explained the four-part test that helps you know if your activities meet IRS regulations.
Proper identification of your QREs can save your business a lot of money each year. The R&D tax credit directly reduces your tax liability dollar for dollar. Small businesses can now use up to $500,000 of R&D credits against employer payroll taxes since 2023, which is a huge benefit.
It makes financial sense to assess your business activities against these qualification criteria. Many companies create qualifying research without even knowing it. This is especially true when you have manufacturing, software development, engineering, and biotech operations. Your development work doesn’t need to be revolutionary – even small improvements to existing products or processes might qualify.
Good documentation is crucial. The IRS wants clear proof of your qualified research activities and related expenses. You should set up systems to track costs and keep proper records. This will help you during any potential audits.
The R&D tax credit helps businesses that create better products and processes. This valuable incentive cuts your tax burden and supports ongoing research and development work. We suggest working with tax professionals who focus on R&D credits. They’ll help you capture all eligible expenses while following IRS rules.
