The R&D Tax Credit: What Counts, What Doesn’t, and How to Claim It

Many Colorado business owners are already conducting research and development. They just are not claiming the credit for it. If your business spends money solving technical problems through experimentation, the R&D tax credit may be one of the most valuable tax provisions available to you.

Key Details

• The R&D tax credit reduces your actual tax bill dollar for dollar, not just taxable income. A $50,000 credit saves $50,000 in taxes. Unused credits carry forward for up to 20 years.
• Most businesses underestimate what qualifies. Manufacturing process improvements, custom software, product reformulation, and prototype testing can all meet the four-part IRS test. The question is whether your activities involve genuine technical uncertainty and systematic experimentation.
• Wages are typically the largest component of a qualifying claim. Employees who directly conduct, supervise, or support qualified research can contribute a portion of their wages to the calculation, based on documented time allocation.
• Pre-revenue and unprofitable businesses have a separate option. Qualified small businesses can apply up to $500,000 of the credit annually against employer payroll taxes instead of income tax liability.
• Two 2026 deadlines matter now. The One Big Beautiful Bill Act (OBBBA) restored immediate expensing for domestic R&D costs and allows eligible small businesses to amend 2022 through 2024 returns, but that window closes July 6, 2026. Form 6765 project-level disclosure (Section G) also becomes mandatory for most filers in 2026.

Industries That Qualify Beyond Technology

The most common misconception is that the R&D tax credit only applies to laboratories, biotech firms, and Silicon Valley software companies. In practice, the IRS test focuses on the nature of the activity, not the industry label.

Manufacturing businesses that develop new production processes, test prototype components, or improve the efficiency of existing fabrication systems often qualify. So do construction firms designing first-in-class structures, food and beverage companies reformulating products, agricultural businesses developing new cultivation techniques, and healthcare companies creating new devices or clinical tools.

Software development qualifies when it involves genuine technical uncertainty and a process of experimentation, whether the software is sold to customers or used internally. Energy businesses developing new methods or equipment and engineering firms testing new designs also frequently find qualifying activities when they look systematically at their work.

The question is not whether you work in a “research industry.” The question is whether your activities meet the four-part test.

The Four-Part IRS Test

Every activity claimed under the R&D tax credit must pass all four parts of this test. The tests are applied separately to each business component, meaning each product, process, software, technique, formula, or invention being developed or improved.

The activity does not have to succeed. Research that fails to produce the intended result can still qualify, as long as it met all four parts during the process. What disqualifies an activity is not failure. It is the absence of genuine uncertainty and systematic experimentation from the start.

According to IRS guidance on qualified research activities, these tests must be applied separately to each business component. A product line with ten components may have some that qualify fully, others that qualify partially under the “shrinking back” rule, and some that do not qualify at all.

Which Costs You Can Include

Qualified research expenses (QREs) are the costs the IRS counts toward your credit calculation. Three categories make up the vast majority of claims.

Employee wages are typically the largest component. Wages paid to employees who directly conduct, supervise, or support qualified research are includable, but only the portion of their time tied to qualifying work. A mechanical engineer who spends 60% of her time developing and testing a new production component can contribute 60% of her wages to the QRE calculation. Time tracking documentation is what substantiates this allocation.

Supplies used and consumed during research qualify, provided they are tangible materials directly used in experimentation and not capitalized as equipment. Prototype materials, test components, and lab consumables are common examples. General administrative supplies and capital equipment do not qualify.

Contract research expenses are costs paid to outside parties to perform qualified research on your behalf. Your business must retain substantial rights in the results and bear the economic risk if the research fails. Sixty-five percent of amounts paid to outside contractors for qualifying research is includable.

One important limitation: according to the IRS Form 6765 instructions, research conducted outside the United States does not qualify, regardless of whether the activity would otherwise meet the four-part test. That matters for businesses with international development teams.

What the Credit Won’t Cover

Understanding exclusions is just as important as understanding what qualifies. Common activities that fail the test include:

• Research conducted after commercial production has already begun on a business component
• Adapting an existing product to a particular customer’s requirements (this is customization, not experimentation)
• Duplicating an existing product from publicly available specifications
• Management studies, market research, efficiency surveys, or quality control testing that does not involve genuine technological uncertainty

Research funded by a government contract or third-party agreement where your company does not bear the financial risk also does not qualify. This catches some contractors and subcontractors off guard, particularly in the government services and defense sectors.

Activities in social sciences, arts, humanities, or business management are excluded by statute, regardless of how systematic they may be. The credit is specifically designed to incentivize hard-science and engineering work conducted within U.S. borders.

Calculating the Credit: Two Methods

There are two methods for calculating the credit. Most businesses should run both and use whichever produces the better result.

The Regular Research Credit (RRC) applies a 20% rate to current-year QREs exceeding a calculated base amount. The base amount uses historical gross receipts and QREs, often reaching back to the 1984 through 1988 period, which makes the RRC difficult for newer businesses to use. When it works, it often produces a larger credit than the alternative.

The Alternative Simplified Credit (ASC) is more accessible and the method most businesses choose. It applies a 14% rate to current-year QREs exceeding 50% of the average QREs for the three preceding years. If no QREs existed in any of those prior years, the rate drops to 6% of current-year QREs. The ASC does not require historical gross receipts data, which makes it workable for startups and businesses without decades of R&D history.

A quick example: A manufacturing company has average QREs of $400,000 over the prior three years. Half of that average is $200,000. If current-year QREs are $600,000, the credit base under ASC is $400,000. At 14%, the federal credit is $56,000. That is $56,000 directly off the company’s federal tax bill, not off taxable income.

Because the credit is incremental (it rewards growth in research spending over a baseline), businesses that have consistently invested in R&D and continue increasing that investment tend to see the largest benefits. If the credit exceeds your current-year tax liability, unused amounts carry forward for up to 20 years.

One planning consideration: claiming the full credit requires reducing your R&D expense deduction by that amount. Alternatively, you can elect a reduced credit and keep the full deduction. Which approach produces a better net result depends on your effective tax rate. A tax advisor who works regularly with business tax planning can model both scenarios for your situation.

Pre-Revenue Companies: Use the Credit Against Payroll Taxes

For businesses that are not yet profitable or carry no income tax liability, the payroll tax election offers a practical alternative. A qualified small business can apply up to $500,000 of the R&D credit annually against its employer Social Security payroll tax liability, for up to five consecutive years.

To qualify, the business must have gross receipts of less than $5 million for the credit year and must have no gross receipts for any tax year prior to the five years before the credit year. In other words, you must be a relatively new company. The election is made on Form 6765 and applied through Form 8974 against quarterly payroll tax filings. The offset takes effect the quarter after you file your income tax return.

For a pre-revenue technology or medical device company investing heavily in development, this provision can provide real cash flow from a credit that would otherwise sit unused for years.

How to File the Claim

1. Identify your qualifying activities. Review your projects against the four-part test above. Focus on work where your team faced genuine technical uncertainty and used experimentation to resolve it. This is where most businesses either find credits they did not know they had or realize certain activities do not qualify.

2. Document the work and allocate costs. For each qualifying project, you need records showing who worked on it, what percentage of their time was spent on qualifying research, which supplies were consumed, and what contractors were involved. The IRS expects this documentation to be contemporaneous, meaning it should be created as the work happens, not reconstructed at tax time. Project descriptions, time tracking reports, design specs, testing logs, and contractor agreements are the most common supporting records. Courts have disallowed claims where businesses could not connect specific employees and costs to specific qualifying activities, even when the underlying work clearly involved genuine R&D.

3. Calculate the credit. Run both the Regular Research Credit and the Alternative Simplified Credit calculations (described above) and use whichever produces the better result. Decide whether to take the full credit with a reduced deduction or the reduced credit with the full deduction. Your CPA can model both.

4. File Form 6765 with your tax return. Form 6765, Credit for Increasing Research Activities, is filed as an attachment to your annual business income tax return. For corporations, that is Form 1120. For partnerships and S corporations, the credit flows through to partners and shareholders on Schedule K-1. Sole proprietors and single-member LLCs report on Schedule C of Form 1040. If you are a qualifying startup electing the payroll tax offset, you will also need Form 8974 filed with your quarterly Form 941.

5. Consider amending prior years. If you did not claim the credit in previous years but had qualifying activities, you can file amended returns for open tax years. The standard window is three years from the original filing date.

Two Deadlines That Affect 2026 Filings

Deadline 1: July 6, 2026. Amended returns for retroactive R&D expensing. The OBBBA permanently restored immediate expensing for domestic research costs, effective for tax years beginning after December 31, 2024. For eligible small businesses (average annual gross receipts of $31 million or less), the law also allows a retroactive election covering 2022 through 2024.

If your business was forced to capitalize and amortize R&D costs over five years during that period, you may be able to amend those returns and recover deferred deductions. The deadline is the earlier of July 6, 2026, or the applicable statute of limitations for each year. If this applies to you, the planning requires coordination between the expensing election and how you treated the R&D credit in those same years. Talk to your CPA before filing.

Deadline 2: Tax years beginning in 2026. Form 6765 Section G becomes mandatory. Section G requires taxpayers to break down qualified research expenses by project, including separating wages into direct research, supervision, and support categories. It is optional for the 2025 tax year but mandatory for most filers starting in 2026 (an exception applies to businesses with $1.5 million or less in QREs and $50 million or less in gross receipts).

If your business has not yet organized R&D activity at the project level, using 2025 as a dry run is advisable. Colorado businesses should also note that state conformity to the new expensing rules varies, and some states have not yet adopted the OBBBA’s approach.

Section 1202 and the R&D Credit: Planning for a Future Exit

If you are a founder or early investor in an R&D-intensive startup structured as a C corporation, the R&D credit is not the only tax provision worth planning around. Section 1202 of the Internal Revenue Code allows eligible shareholders to exclude up to 100% of the capital gains from selling qualified small business stock (QSBS), potentially sheltering millions of dollars from federal tax when the company is eventually sold.

The OBBBA expanded Section 1202 significantly for stock issued after July 4, 2025. The key changes include a higher per-shareholder exclusion cap (now the greater of $15 million or 10 times your adjusted basis, up from $10 million), a higher gross asset ceiling for the issuing corporation ($75 million, up from $50 million), and a new tiered holding period that provides partial exclusions at three and four years rather than requiring a full five-year hold for any benefit.

To qualify, the stock must be in a domestic C corporation, acquired at original issuance in exchange for cash, property, or services. The corporation must use at least 80% of its assets in an active qualified trade or business, and its gross assets cannot exceed $75 million at the time of issuance.

Certain industries are excluded from QSBS eligibility, including professional services (law, accounting, consulting, financial services), banking, insurance, and hospitality. However, many of the same industries that qualify for the R&D credit, such as manufacturing, technology, medical devices, and engineering, can also qualify for QSBS treatment.

The connection between the R&D credit and Section 1202 is practical. Founders doing qualifying research in a C corporation can potentially benefit from the R&D credit (or the payroll tax offset) during the development years and then exclude a significant portion of the gain when the company is sold. The OBBBA’s restoration of immediate R&D expensing also affects how gross assets are calculated, which may help some companies stay under the $75 million threshold longer.

A few important caveats: Section 1202 is a federal provision, and not all states conform. California, Alabama, Mississippi, and Pennsylvania do not allow the exclusion at all. Colorado does conform, but state rules can change. The planning involved, particularly around entity structure, holding periods, and the interaction with other OBBBA provisions, is something to discuss with your tax advisor well before an exit is on the table.

Working with WhippleWood

WhippleWood works with Colorado businesses across manufacturing, healthcare, energy, construction, and technology to identify R&D credits they may be leaving unclaimed and to build the documentation processes that support those claims through audit. If you have not evaluated whether your development activities qualify, or if the 2026 changes affect how you should be treating R&D costs, our business tax team can walk through the specifics of your situation.

The credit is available, the rules are workable, and the 2025 to 2026 window includes timing opportunities that do not come around often. Contact us to start the conversation.