The research credit rewards qualified research spending, and it is one of the credits the IRS examines closely. Claims fail on documentation more often than on the idea that the client does research. A CPA firm that handles client tax returns should know what the test requires, how the credit is computed and what evidence the client has to produce. This article covers the credit under section 41 and the Form 6765 instructions. The companion article on expensing research costs is section 174A after the 2025 legislation.
The four-part test
The instructions to Form 6765 state that qualified research must satisfy four tests, applied separately to each business component of the taxpayer:
- Permitted purpose. The activity relates to a new or improved function, performance, reliability or quality of a business component.
- Technological in nature. The activity fundamentally relies on principles of the physical or biological sciences, engineering or computer science.
- Elimination of uncertainty. The taxpayer intends to discover information that would eliminate uncertainty about the capability, method or appropriate design of the business component.
- Process of experimentation. Substantially all the research activities are elements of a process of experimentation for a qualified purpose.
An activity that meets all four counts as qualified research unless it falls into one of the exclusions in section 41(d)(4). A "business component" is the product, process, software, technique, formula or invention the research relates to. The test is applied component by component, so a company with ten projects has ten analyses.
Qualified research expenses
The Form 6765 instructions define qualified research expenses as the sum of in-house research expenses and contract research expenses paid or incurred in a trade or business:
- Wages for people who conduct, directly supervise or directly support qualified research.
- Supplies used in qualified research.
- Computer rental or lease costs for computers located off the taxpayer's premises that the taxpayer does not operate or primarily use.
- Contract research. Generally 65 percent of amounts paid to others for qualified research. Qualified research consortiums get 75 percent, and certain energy research payments by eligible small businesses, universities and federal laboratories get 100 percent.
Two ways to compute the credit
- Regular credit. Computed using qualified research expenses, a fixed-base percentage and average gross receipts. If the taxpayer does not elect the reduced credit, the rate is 20 percent of the computed amount.
- Alternative simplified credit (ASC). Computed from current-year qualified research expenses and the expenses for the prior three years. Once the ASC is elected, the instructions state it applies to the current tax year and all later years unless revoked as permitted.
The section 280C election, made on a timely filed original return, reduces the credit rate to 15.8 percent under the regular method and applies a 79 percent factor under the ASC. If the taxpayer does not make the election, it must reduce its research expenditures under section 174A by the credit amount. The instructions note that Public Law 119-21 added section 174A to the Code.
Payroll tax election for qualified small businesses
A qualified small business is a corporation, including an S corporation, or a partnership with gross receipts under $5 million for the tax year, and with no gross receipts before the five-tax-year period ending with that year. Any other person can qualify if it meets the same two requirements counting the aggregate gross receipts of all its trades or businesses. Tax-exempt organizations under section 501 do not qualify. The IRS states that for tax years beginning after December 31, 2022 the election amount is up to $500,000 of the credit. The election is made on Form 6765 with the timely filed original income tax return, and it cannot be made for a tax year if it was made for 5 or more preceding tax years. The portion used against payroll tax is allowed starting with the first calendar quarter that begins after the return is filed. The credit is then claimed on Form 8974 attached to Form 941, 943 or 944. The credit first reduces the employer share of Social Security tax, up to $250,000 per quarter, and any remainder reduces the employer share of Medicare tax. Unused amounts carry forward to the next quarter. Form 8974 cannot be filed unless the income tax return with the Form 6765 election has been filed.
Documentation the IRS expects
Contemporaneous records are the central requirement. For each business component, build a file that contains:
- Project description. Purpose, technical uncertainty and the alternatives considered.
- Experimentation evidence. Design iterations, test plans and results, prototypes, failed approaches and code commits.
- People and time. Who worked on the project and what they did, supported by time records or reasonable, documented allocations, tied to payroll.
- Supplies and contract costs. Invoices, contracts and statements showing who bore the risk and who owned the results.
- Exclusions analysis. Why the work does not fall into an excluded category.
- Reconciliation. Qualified research expenses reconciled to the general ledger and to the amounts deducted or capitalized under section 174A.
Common reasons claims fail
- Treating routine development or quality control as research.
- Stating a conclusion without evidence of a process of experimentation.
- Allocating wages by estimate with no support.
- Including contract research where the client does not bear the economic risk or does not own the results.
- Failing to reconcile expenses to the return.
The firm's engagement structure
- Scope. Decide whether the firm studies the credit itself or reviews a specialist's work. The firm remains responsible for the return it signs.
- Interviews. Speak with engineers, developers and project leads, not only finance.
- Quantification. Compute under both methods and compare.
- Return and election. Record the section 280C decision and the payroll election.
- Retention. Keep the file for the period the return is open.
See circular 230 competence and delegation on relying on others for specialist work.
FAQ
Is the credit available to a startup with no income tax?
A qualified small business can elect to apply a portion against payroll taxes, up to the election cap.
Are software development costs eligible?
They can be, if the activity meets the four-part test for the business component.
Does the credit reduce the deduction?
Unless the taxpayer makes the section 280C election, research expenditures under section 174A are reduced by the credit amount.
CORAA prepares ready-to-review audit files for US CPA firms; see /us.
Sources
- IRS, Instructions for Form 6765 (12/2025): https://www.irs.gov/instructions/i6765
- IRS, Qualified small business payroll tax credit for increasing research activities: https://www.irs.gov/businesses/small-businesses-self-employed/qualified-small-business-payroll-tax-credit-for-increasing-research-activities
- IRS, Instructions for Form 8974: https://www.irs.gov/instructions/i8974
- IRS, About Form 8974: https://www.irs.gov/forms-pubs/about-form-8974
Part of CORAA University · Tax and compliance for CPA firms: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error