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R&D Tax Credit Requirements: Who Qualifies and the Four-Part Test
R&D tax credit requirements come from the four-part test in IRC 41(d). The costs must be domestic research expenses under section 174A, the work must rely on engineering, computer science or the physical or biological sciences, it must aim at a new or improved business component, and at least 80% of it must be a process of experimentation. Eight kinds of work are excluded.
Who qualifies for the R&D tax credit depends on what a business does, not how big it is or which industry it is in. The IRS applies the requirements of section 41(d) and Treas. Reg. 1.41-4 project by project: every product, process, piece of software, technique, formula or invention is tested on its own. One company can have a project that qualifies next to one that does not.
This guide covers each part of the four-part test as the regulations define it, the shrinking-back rule for projects that fail as a whole, the eight exclusions, the extra hurdle for internal-use software, when customer-funded work drops out, and whose wages count. For what the credit is worth and how it is claimed, start with what the R&D tax credit is and how it works.
The four-part test at a glance
| Part | The question | What the regulations add | Where |
|---|---|---|---|
| 1. Section 174 test | Are the costs research or experimental expenditures, and since 2025 domestic ones under section 174A? | Costs in the experimental or laboratory sense: activities meant to remove uncertainty about capability, method or the right design | IRC 41(d)(1)(A); Treas. Reg. 1.174-2 |
| 2. Technological information | Is the work meant to discover information that is technological in nature? | The work relies on the physical or biological sciences, engineering or computer science; it need not go beyond what skilled professionals already know | IRC 41(d)(1)(B)(i); Treas. Reg. 1.41-4(a)(3), (4) |
| 3. Business component | Is that information meant to help develop a new or improved business component? | A product, process, computer software, technique, formula or invention you sell, lease, license or use; a production process is its own component | IRC 41(d)(1)(B)(ii), (d)(2) |
| 4. Process of experimentation | Is substantially all of the work a process of experimentation for a qualified purpose? | 80% or more of the activities, by cost or another consistent, reasonable measure; the purpose must be function, performance, reliability or quality | IRC 41(d)(1)(C), (d)(3); Treas. Reg. 1.41-4(a)(5), (6) |
All four parts must be met for the same business component, and even then the eight exclusions in section 41(d)(4) can remove the work. The sections below take each piece in turn.
Part 1: the section 174 test
For tax years beginning after December 31, 2024, P.L. 119-21 requires research whose costs are treated as domestic research or experimental expenditures under section 174A. The credit regulations, last revised before 2025, still refer to section 174 and to Treas. Reg. 1.174-2, which is where the definition lives. Under that regulation, costs qualify when they are research and development costs in the experimental or laboratory sense: spending on activities meant to discover information that would eliminate uncertainty about developing or improving a product. Uncertainty exists when the information you have does not establish the capability or method for the development, or the appropriate design.
The test looks at the nature of the activity, not at how advanced the product is, and the ultimate success, failure, sale or use of the product does not matter. Some spending never passes: ordinary quality-control testing, efficiency surveys, management studies, consumer surveys, advertising or promotions, buying someone else’s patent, model, production or process, and research tied to literary, historical or similar projects. Section 174A adds three rules of its own. Costs to acquire or improve land or depreciable property are not research expenditures, though depreciation on research equipment is. Mineral exploration costs are out. And every amount paid or incurred to develop software is treated as a research or experimental expenditure.
Part 2: technological in nature
Information is technological in nature when the process used to discover it fundamentally relies on principles of the physical or biological sciences, engineering or computer science. You may use existing technology and existing principles to get there. The regulations drop two tests people often assume: you do not have to seek information that exceeds, expands or refines the common knowledge of skilled professionals in the field, and you do not have to succeed.
A patent helps but is not required. Under Treas. Reg. 1.41-4(a)(3)(iii), a patent issued by the Patent and Trademark Office, other than a design patent, is conclusive evidence that you discovered technological information meant to eliminate uncertainty. Two limits run the other way: using computers to store, collect, manipulate or distribute data does not by itself show that qualified research took place, and research in the social sciences, including economics, business management and behavioral sciences, is excluded outright.
Part 3: a new or improved business component
The information must be meant to help develop a new or improved business component, which section 41(d)(2) defines as any product, process, computer software, technique, formula or invention to be held for sale, lease or license, or used in your own trade or business. The whole test is applied separately to each one. A plant process, machine or technique for commercial production is its own business component, apart from the product it makes, and Treas. Reg. 1.41-4(b)(1) requires the product work and the process work to each pass without leaning on the other.
The component count matters on the return. Form 6765 asks for the number of business components on line 37, and when Section G applies it reports QREs component by component, labeled as a product, a process or all others (software, techniques, formulas and inventions).
Part 4: the process of experimentation and the 80% rule
A process of experimentation is designed to evaluate one or more alternatives to reach a result when the capability or method of reaching it, or its appropriate design, is uncertain at the start. Treas. Reg. 1.41-4(a)(5) describes three steps: identify the uncertainty, identify alternatives meant to eliminate it, and identify and conduct a process of evaluating those alternatives, such as modeling, simulation or systematic trial and error. The process must be evaluative and generally capable of weighing more than one alternative. Uncertainty about design alone is enough to start one, but it does not turn every activity on the project into experimentation.
The experimentation must serve a qualified purpose under section 41(d)(3): a new or improved function, performance, reliability or quality. Work driven by style, taste, cosmetic or seasonal design factors never qualifies. Then comes the 80% rule. Substantially all of the activities for a business component must be elements of a qualifying process of experimentation, which the regulations set at 80% or more, measured on a cost or other consistently applied reasonable basis. When a component meets it, the remaining 20% or less can count too, provided those activities pass the section 174 test and are not excluded. This is a different 80% rule from the one for an employee’s wages, covered below.
When a project fails as a whole: the shrinking-back rule
Under Treas. Reg. 1.41-4(b)(2), the requirements apply first to the whole business component. If it fails, they apply to the most significant subset of its elements, and the shrinking continues until a subset passes or the most basic element is reached and fails. The rule is used only when the overall component fails, and it is never itself a reason to exclude research.
The eight exclusions
Section 41(d)(4) lists work that never counts, even when it would otherwise pass. The regulations in Treas. Reg. 1.41-4(c) fill in each one:
| Exclusion | What it covers | Detail from the regulations |
|---|---|---|
| After commercial production (41(d)(4)(A)) | Work done once the component is ready for commercial sale or use, or meets your basic functional and economic requirements | Treated as after production: preproduction planning, tooling-up, trial production runs, troubleshooting faults in production equipment, collecting production data, and debugging flaws. A new project to improve an existing product starts fresh, and a manufacturing process runs on its own clock. |
| Adaptation (41(d)(4)(B)) | Fitting an existing component to one customer’s particular requirement or need | A component is not excluded just because it is being built for a specific customer. |
| Duplication (41(d)(4)(C)) | Reproducing an existing component from the item itself, plans, blueprints, detailed specifications or public information | Examining someone else’s product while developing your own is not duplication by itself. |
| Surveys and studies (41(d)(4)(D)) | Efficiency surveys, management functions or techniques, market research and advertising, routine data collection, routine quality-control testing | Management functions include financial data and analysis, training programs, organization plans and management-driven production changes such as rearranging work stations. |
| Internal-use software (41(d)(4)(E)) | Software built mainly for your own general and administrative functions | Eligible only if it also passes the high threshold of innovation test, below. |
| Foreign research (41(d)(4)(F)) | Research conducted outside the United States, Puerto Rico and U.S. possessions | In-house costs for work done partly abroad are apportioned and only the U.S. share counts, with a limited exception in the wage rules; for contract research, 65% of the U.S. portion counts. |
| Social sciences, arts, humanities (41(d)(4)(G)) | Research in those fields | Includes economics, business management and behavioral sciences. |
| Funded research (41(d)(4)(H)) | Research to the extent another person or a government entity pays for it | Worked out under Treas. Reg. 1.41-4A(d), below. |
Internal-use software and the high threshold of innovation test
Software developed mainly for your own internal use gets a stricter test under Treas. Reg. 1.41-4(c)(6), in force for tax years beginning on or after October 4, 2016. Internal use means general and administrative functions that support the business: financial management (accounts payable and receivable, budgeting, cost accounting, financial reporting, tax), human resources management (recruiting, hiring, training, personnel records, payroll, benefits) and support services (data processing, facilities, marketing, legal, compliance, printing, security). Software built for a related company’s internal use counts as internal use too.
Software is not internal use if it is developed to be sold, leased, licensed or otherwise marketed to third parties, or to let you interact with third parties or let them initiate functions or review data on your system. Intent at the start of development decides, and later improvements made with a different intent are judged separately. Dual function software, built for both kinds of use, is presumed internal use. You can carve out any subset that only serves third parties, and for the rest a safe harbor lets 25% of its QREs count if third-party use is reasonably expected to be at least 10%, measured by an objective method such as processing time, data transferred or user interface screens.
Internal-use software must clear all three parts of the high threshold of innovation test:
- Innovative. If the development succeeds, it would produce a reduction in cost, an improvement in speed or another measurable improvement that is substantial and economically significant. This is an objective standard, not a test of novelty.
- Significant economic risk. You commit substantial resources, and there is substantial uncertainty, because of technical risk, that you would recover them within a reasonable period. This asks for more uncertainty than other components.
- Not commercially available. You could not buy, lease or license software and use it for the intended purpose without modifications that would themselves meet the first two parts.
The test does not apply to software used in qualified research itself, software used in a production process that meets the four-part test, or a new or improved hardware and software package developed together as one product and used directly to provide services. Form 6765 Section G asks for the software type of each component (internal use, dual function, excepted, or not internal use), so the classification belongs in your records from the start.
Funded research: when a customer or a grant pays
Research is excluded to the extent another person or a government entity funds it, and Treas. Reg. 1.41-4A(d) sets out how to measure that. Every agreement between the researcher and other parties is considered, not only research contracts. Payments that depend on the research succeeding are not funding; they are treated as paying for a result. If the researcher keeps no substantial rights in the research, for example because the customer gets the exclusive right to exploit the results, the work is treated as fully funded. Incidental benefits such as experience gained are not substantial rights, and having to pay to use the results means you did not keep them.
When the researcher does keep substantial rights, the research is funded to the extent of the payments it is entitled to, and its otherwise qualified costs are reduced by that amount. A taxpayer that can establish its total research costs and meets the regulation’s other conditions may instead spread the funding pro rata across qualified and other costs, but never apply less than 65% of the funding against the qualified ones. The analysis runs project by project, and if the funding cannot be determined when the return is filed, the research is treated as fully funded until an amended return corrects it.
The paying side has its own rules in Treas. Reg. 1.41-2(e): a payer can count 65% of the fee as contract research only if the contract predates the work, the research is done on the payer’s behalf with a right to the results (not necessarily exclusive), and the payer owes the fee whether or not the research works. Four common arrangements:
| Contract terms | Company doing the research | Company paying for it |
|---|---|---|
| Fixed fee; the performer keeps the right to use the results | Funded to the extent of the fee, so its otherwise qualified costs are reduced by that amount | Can count 65% of the fee as contract research |
| Fixed fee; the customer gets exclusive rights and the performer keeps none | Treated as fully funded; none of its costs count | Can count 65% of the fee as contract research |
| Paid only if the research works; the performer keeps rights | Not funded, because success-based pay is payment for a result; its own qualified costs can count | Not contract research, for the same reason |
| Paid only if the research works; the performer keeps no rights | Nothing counts | Nothing counts |
Whose work counts: qualified services
Wages count only for qualified services under section 41(b)(2)(B): engaging in qualified research, or directly supervising or directly supporting it. Treas. Reg. 1.41-2(c) draws the lines this way:
| Role | Counts? | Rule |
|---|---|---|
| Engineer, scientist or developer running the experiments | Yes | Engaging in qualified research: the actual conduct of the work |
| First-line manager who directs that work but may not run tests | Yes | Direct supervision means immediate, first-line management |
| Director or executive above the first-line managers | No | Higher-level supervision is excluded even when that person is a trained scientist |
| Technician who cleans the test equipment; staff who type up results or assemble test data; a machinist making a part for a prototype | Yes | Direct support of the people doing or supervising the research |
| Payroll staff, accountants, janitors doing general cleaning, and officers overseeing finance or personnel | No | General and administrative services, even inside a research department |
| Outside firm or contractor doing the research | Not as wages | 65% of the qualifying fee can count as contract research |
When someone splits time between research and other work, only the share of wages for qualified services counts, generally by the ratio of time spent, unless another method is shown to be more appropriate. If qualified services make up 80% or more of that person’s wages for the year, all of their wages count. Officers are not excluded: Form 6765 line 38 asks how much of the research wages went to officers, and an officer who is also a shareholder is reported the same way. For self-employed individuals treated as employees under section 401(c)(1), earned income counts as wages.
The trade or business requirement
QREs must be paid or incurred in carrying on a trade or business, which the regulations read the same way as section 162. Costs incurred before a new business begins, as opposed to expanding an existing one, generally fail that test, and so does contract research on a product meant to be licensed to others and not used in your business. Section 41(b)(4) relaxes the rule for start-ups: in-house research counts if, when the costs are paid or incurred, the principal purpose is to use the results in the active conduct of a future trade or business of the company or its group.
Illustrations: does it qualify?
| Situation | Likely treatment | Why |
|---|---|---|
| A team building a routing feature for software it licenses to customers tests three algorithms against a latency target, and that testing is at least 80% of the project’s activities | Can qualify | Software held for license is not internal-use software; the four-part test applies as usual |
| The same team builds an internal expense-approval tool | Qualifies only if it also passes the high threshold of innovation test | Expense approval is a financial management function, so it is internal-use software |
| A manufacturer picks a new product color after surveying customers | Does not qualify | Cosmetic purpose, and market research is excluded |
| A supplier resizes an existing part to one customer’s drawings using known methods | Does not qualify | Adaptation of an existing component with no process of experimentation |
| A plant designs a fixture no vendor sells, testing several designs to handle a new material | Can qualify | The production process is its own business component |
| A contract developer is paid a fixed fee and hands the customer exclusive rights to the code | Does not qualify for the developer | Fully funded research; the customer may count 65% of the fee |
Documenting the four parts
Treas. Reg. 1.41-4(d) requires records in sufficiently usable form and detail to show that the expenses claimed are eligible. Keep them by business component: the uncertainty at the start, the alternatives considered, how they were evaluated, who did the work, how their time was tracked, and the contracts that settle any funding question. The same structure answers an IRS refund claim, which must name every business component, the research activities for each and total QREs, per the IRS research credit claim FAQs. The R&D tax credit documentation checklist turns this into a list you can work through each year, and how to calculate the R&D tax credit picks up once the qualifying work is identified.
Established companies that find qualifying work in past years can often amend open returns. That is the Credit Recovery service on the Tax Planning page.
Anthony leads sales at Business Executive Group, a national HR services firm. BEG helps clients find out whether their technical work qualifies; licensed tax professionals at BEG's tax partner make that determination and file the credit.
Sources: 26 U.S.C. 41; 26 U.S.C. 174A; Treas. Reg. 1.41-4, qualified research (eCFR); Treas. Reg. 1.41-4A(d), funded research (eCFR); Treas. Reg. 1.41-2, qualified research expenses (eCFR); Treas. Reg. 1.174-2, research or experimental expenditures (eCFR); IRS, Instructions for Form 6765 (Rev. December 2025); IRS, Form 6765 (Rev. December 2024); IRS, Research credit claims (Section 41) on amended returns FAQs. Rules checked against these sources on September 25, 2026. This is general information, not tax advice for your situation. Tax services are provided by licensed tax professionals under a separate engagement agreement. BEG does not provide tax advice.
R&D tax credit requirements: common questions
What are the four parts of the R&D tax credit test?
Section 41(d) requires that the costs be domestic research or experimental expenditures under section 174A; that the work seek information that is technological in nature; that the information be meant to develop a new or improved business component; and that substantially all of the work, 80% or more, be a process of experimentation aimed at function, performance, reliability or quality.
What qualifies for the R&D tax credit?
Activities, not companies, qualify. Work on a product, process, computer software, technique, formula or invention qualifies when it passes the four-part test and is not excluded by section 41(d)(4). The spending that counts is wages for qualified services, supplies, certain computer rental and 65% of contract research.
Does software development qualify for the R&D tax credit?
Often. Software sold, licensed or used to interact with customers is tested under the four-part test like any other component. Software built mainly for your own general and administrative functions, such as accounting or HR, is internal-use software and must also pass the high threshold of innovation test in Treas. Reg. 1.41-4(c)(6).
What does “substantially all” mean for the R&D credit?
At least 80% of the research activities for a business component must be elements of a process of experimentation for a qualified purpose, measured by cost or another consistently applied reasonable basis. If that is met, the other 20% or less can count too, as long as it passes the section 174 test and is not excluded.
Does research have to succeed to qualify?
No. The regulations say the discovery requirement does not require that you succeed in developing the new or improved component, and the section 174 regulations say ultimate success or failure is not relevant.
Is there a size or revenue requirement for the R&D tax credit?
Not for the credit against income tax. Size tests apply to extras: the payroll election needs gross receipts under $5 million and no receipts before the five-year window, and filers with QREs of $1.5 million or less and average gross receipts of $50 million or less can skip Form 6765 Section G on an original return.
Can research a customer pays for qualify?
Only to the extent it is not funded. If you keep no substantial rights in the results, the work is treated as fully funded and none of it counts. If you keep substantial rights, your qualified costs are reduced by the payments. Payments due only if the research succeeds are not funding.
Do contractors’ costs count toward the R&D tax credit?
Yes, at 65% of the amount paid for qualified research, under section 41(b)(3). The agreement must come before the work, give you a right to the results, and leave you owing the fee whether or not the research works. A success-contingent portion does not count.
Do marketing, quality control or management projects qualify?
No. Section 41(d)(4)(D) excludes efficiency surveys, management functions and techniques, market research and advertising, routine data collection and routine quality-control testing.
Can a company with no revenue yet claim the credit?
Yes, for in-house research. Section 41(b)(4) treats a start-up as carrying on a trade or business if its principal purpose is to use the research results in a future active business. Unused credit carries forward, and a qualified small business can elect to use it against payroll tax.
What is the shrinking-back rule?
If a whole business component fails the four-part test, Treas. Reg. 1.41-4(b)(2) tests the next most significant subset of its elements, then the next, until a subset passes or the most basic element fails. It rescues qualifying parts of a larger project; it is never a reason to exclude work.
R&D Payroll Tax Credit
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Tax services are provided by licensed tax professionals under a separate engagement agreement. BEG does not provide tax advice.
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