Research & Development (R&D) Tax Credit for Small Business Explained

Originally published November 17, 2021.  Updated November 2025 to reflect changes from the One Big Beautiful Bill Act and IRS Rev. Proc. 2025-28.

If you are a small business owner, you know that you need to pay taxes and that paying more than you are required to pay can make it difficult to achieve your business goals. In other words, you need to meet your legal obligations and take advantage of any tax credits or deductions that apply to you to reduce your income tax liability.

At CMP, we work with small business owners every day to help ensure they do not miss out on tax credits. One of the credits that we find is most often misunderstood is the Research & Development (R&D) Tax Credit. Businesses that qualify often don't take it. Is that a mistake you're making? Keep reading to discover if you are eligible.

What is the Federal R&D Tax Credit?

The Research and Development Tax Credit (sometimes called the Small Business R&D Tax Credit) was a provision in the Economic Recovery Tax Act (ERTA) of 1981. In a troubled economy, such as the US being in a recession in 1981, the ERTA was intended to be a stimulus. At the time, members of Congress felt that declines in research spending by American companies were harming the country’s economic growth and competitiveness in the world marketplace.

The official title of the provision regarding R&D is the Credit for Increasing Research Activities. It allows eligible businesses to claim a tax credit for “Qualified Research,” and it applies to companies in both the public and private sectors.

Originally, the R&D credit was intended to expire on December 31, 1985. It has been extended a total of 15 times, and in 2015, Congress made it a permanent part of the tax code. It can be found under Internal Revenue Code section 41.

Does the R&D Tax Credit Increase R&D Spending?

If you have never taken the R&D tax credit before, you might wonder if you will need to increase your R&D spending to qualify. The short answer is probably “no”. If you are already spending money to research and develop new products, then you may qualify to take the R&D credit. You will not necessarily need to spend any additional money to take the credit.

If your company sees the R&D tax credit as an opportunity to put some money into research and offset it with the credit, you might decide to make room in your budget for R&D to help offset your expenses, but that is not a requirement.

How Does the R&D Tax Credit Work?

Companies can claim a credit under §41 for qualified research expenses (QREs). If they also deduct those costs under §174A, coordination under §280C requires either reducing the deduction or electing the reduced credit on Form 6765. Many states also offer a Research and Development (R&D) credit.

If your company conducts qualified research, you should look into claiming this tax credit. In some circumstances, you may be able to claim the credit retroactively if you have not taken it before and have qualified research expenses.

Learn more about how the Big Beautiful Bill changes R&D tax credits and what it means for innovative businesses this year.

Can a Sole Proprietor Claim the R&D Tax Credit?

Sole proprietorships make up approximately 12% of small businesses in the US and many entrepreneurs start their businesses as sole proprietorships before reorganizing as LLCs or S corporations. When you think of R&D, you might think of major corporations, but the truth is that many small businesses also qualify for the R&D credit.

If you have a business that is a sole proprietorship, you can qualify to take the R&D tax credit on the federal level. The limits are the same regardless of the size of your business, but as a qualified startup, you can take the credit to offset your payroll taxes instead of your income taxes.

Is the R&D Tax Credit Taxable Income?

People sometimes confuse tax deductions with tax credits. A tax deduction reduces the amount of your taxable income. For example, if you earned $100,000 in gross income, you can claim the standard deduction to reduce your income. Any other deductions you took, such as those for charitable donations, would also reduce your taxable income and have the potential to move you into a lower income bracket.

By contrast, a tax credit directly reduces the amount of taxes you pay. If your business had a total tax bill of $300,000 for the year and you qualified for a $200,000 R&D credit, you would subtract the R&D credit from your tax bill and reduce your balance to $100,000. The money you spend on qualified research activities is used to calculate the credit that offsets the amount of tax owed.

Is the R&D Tax Credit Refundable?

The federal R&D tax credit is not refundable; however, it can be carried forward.

Payroll-tax offset (Inflation Reduction Act 2022):

Qualified small businesses may apply for up to $500,000 per year of the credit to offset payroll taxes.

• The first $250 k applies to the employer Social Security tax.
• The next $250 k applies to the employer Medicare tax.
• Any unused portion carries forward to future quarters via  Form 8974.

What Qualifies for the R&D Tax Credit?

While R&D might not be the focus of your company’s activities, any company that meets and resolves technological challenges may be eligible to take the credit. The most common way of determining whether research is qualified is a four-part test. Here are the criteria established by the IRS’s four-part test:

1. Elimination of uncertainty. A company taking the credit must demonstrate that it has tried to eliminate uncertainty in its development or improvement of a process or product.
   
   
2. Process of experimentation. A company taking the credit must demonstrate that it has explored and evaluated alternatives for achieving the desired result. This demonstration may include modeling, simulation, systematic trial and error, or other methods.
   
   
3. Technological in nature. A company taking the credit must use a process of experimentation that relies on the so-called “hard sciences,” which include biology, chemistry, computer science, engineering, and physics.
   
   
4. Qualified purpose. A company taking credit must conduct research, the purpose of which is to create a new or improved product or process, or to enhance its function, performance, quality, or reliability.
   

In our experience at CMP, it is not uncommon for businesses that don’t consider themselves innovators to apply this test to their activities and discover that they are eligible for the R&D credit. In other words, don’t assume that you aren’t eligible without looking at your activities through the proper lens as defined in the tax code. 

To substantiate a claim, maintain detailed project documentation linking each activity and employee time record to the business component tested and the technical uncertainty addressed, consistent with the IRS Audit Technique Guide.

What Qualified Research Expenses Apply to the R&D Tax Credit?

If you do feel that you qualify to take the R&D Tax Credit, you must next review your Qualified Research Expenses to calculate the credit you are due. These fall into four categories as follows:

1. Wages paid to your employees for qualified services, including amounts that are considered wages for federal income tax withholding.
2. Supplies, which are defined as any tangible property (excluding lands or improvements to land and property that is subject to depreciation) used or consumed in the R&D process.
3. Contract research expenses that your company pays to a third party for performing QRAs on behalf of your company, regardless of the success of the research being conducted. Contract research expenses are allowed at 65% of the actual cost incurred.
4. Basic research payments that your company makes to qualified educational institutions or scientific research organizations as part of your R&D activities. Basic research payments are allowed at 75% of the actual cost incurred.
   

You should plan on getting the advice of an experienced CPA or tax attorney to calculate your R&D credit, particularly if you have not taken it in the past. The experts at CMP can be very helpful in this area.

What Activities Are Not Qualified R&D Activities?

We have talked about the activities that would qualify your company to take the R&D Tax Credit, but we think it is important to let you know that some activities specifically do not qualify. There are 10 types of primary activities that are specifically excluded, as follows:

• Research that you conduct after you have started commercial production or implementation of the business component
• Adaptation or duplication of existing business components
• Studies, surveys, and activities related to management techniques or functions
• Routine data collection
• Routine and ordinary testing or quality control inspections
• Certain internal-use software (IUS)—software used only for general administrative or back-office functions—qualifies only if it meets the high-threshold-of-innovation test and the standard four-part test.
• Software developed for sale, licensing, or enabling customer interaction is not treated as IUS and may qualify under the ordinary §41 rules.
• Research conducted outside of the United States
• Research in the social sciences (as differentiated from the hard sciences listed earlier)
• Funded research
• Costs associated with acquiring fixed assets used in your regular trade or business

R&D Tax Credit Carryforward Period

The R&D tax carryforward period enables businesses that qualify for the credit to fully utilize it, even if they have spent more on R&D than they owe in taxes. The carryover period allows you to carry forward unused credits for up to 20 years.

Keep in mind that you may be able to go back up to three years to calculate the R&D credit if you did not take it when you filed your taxes. You can then amend your tax return and amortize the credit using the carryforward period until you have taken the full amount for which your company is eligible. 

Payroll-tax offset amounts elected on Form 6765 carry forward from quarter to quarter through Form 8974 until fully utilized.

Necessary Documentation to Claim the R&D Tax Credit

The IRS requires sufficient documentation to substantiate the qualified activities that were performed and to substantiate the applicable qualified expenses claimed for the credit.

Some examples of documentation that should be kept include the following:

• Chart of accounts for the general ledger
• Organizational charts
• Payroll records, specifically the wages paid for R&D activities
• Lists of all supplies used in QREs
• Copies of contracts with outside providers and vendors related to QREs
  

In other words, you need to retain records that document the R&D your company has completed and your calculations of the credit, and we are very experienced in helping taxpayers adequately meet the documentation requirements.

How Did Tax Reform Affect the R&D Tax Credit?

The PATH Act of 2015 is the law that permanently extended the R&D credit. As a reminder:

1. Small businesses may take the R&D Tax Credit against their alternative minimum tax (AMT) liability for tax years beginning after December 31, 2015.
   
   
2. Startup businesses with no federal tax liability and gross receipts of less than $5 million may take the R&D Tax Credit against their payroll taxes for tax years beginning after December 31, 2015.
   

Update for 2025:

The One Big Beautiful Bill Act (OBBBA) signed July 4, 2025, changed how U.S. companies deduct research and experimental (R&E) expenses under the Internal Revenue Code.

For tax years beginning after December 31, 2024, the new Section 174A allows taxpayers to deduct domestic research and experimental (R&E) costs immediately. The 2017 Tax Cuts and Jobs Act’s five-year amortization rule no longer applies to U.S. research.

Foreign R&E costs remain capitalized and amortized over 15 years.

Businesses may also apply a transition rule to catch up unamortized 2022–2024 domestic R&E costs in 2025 (or over 2025–2026) under IRS Rev. Proc. 2025-28.

Domestic vs. Foreign R&D under Current Law

Domestic research → immediate deduction under §174A (for years after 12/31/2024).

Foreign research → must be capitalized and amortized over 15 years.

Planning point: Businesses performing research both in and outside the U.S. should track costs separately—location now directly affects deduction timing.

2025 Coordination & Elections

Coordination with the credit:

When a company claims the §41 R&D credit, it must either

(a) reduce its §174A deduction by the credit amount, or

(b) elect the reduced-credit method on Form 6765 under §280C.

Accounting-method change:

IRS Rev. Proc. 2025-28 outlines the statement requirements and automatic method-change procedures for switching from amortization to immediate expensing.

Retroactive option:

Certain small businesses (avg. gross receipts ≤ ≈ $31 million for the prior 3 years) can elect retroactive relief back to 2022.

Reduce Tax Liability with the R&D Tax Credit

As a business owner, it is essential to take every tax credit that's available to you. By reducing your tax burden, you can put more money into your business and increase your chances of long-term success.

Do you need help determining whether your business qualifies for the R&D credit? CMP can help! We offer R&D credit tax credit services to help your business identify and document qualifying activities to claim the credits you are due. Click the button below to schedule a free consultation today!