What Expenses Qualify for the R&D Tax Credit?
The credit is calculated as a percentage of three categories of spending — collectively called Qualified Research Expenses (QREs). Understanding what counts helps you estimate the size of your potential credit.
The Three Categories of QREs
The IRS defines three types of expenses that count toward your R&D credit calculation. Most businesses are surprised to learn that employee wages — not lab equipment — make up the majority of qualifying expenses.
Employee Wages
Typically 60–70% of QREsThe largest and most valuable category. Wages paid to employees who directly perform, supervise, or support qualifying research activities count as QREs. This includes engineers, developers, scientists, technicians, and their direct managers.
Three levels of qualifying employees:
Important: Only the percentage of time spent on qualifying activities counts. If an engineer spends 60% of their time on qualifying R&D, 60% of their wages are QREs.
Supplies & Materials
Typically 10–20% of QREsTangible property used and consumed in the research process. This includes prototypes, test materials, lab supplies, and components used during experimentation. The key word is "consumed" — materials used up in the testing process, not capital equipment that lasts for years.
Contract Research
65% of qualifying contractor payments65% of amounts paid to third-party contractors for qualifying research counts as a QRE. Two conditions must be met: (1) your company must retain substantial rights to the research results, and (2) your company must bear the economic risk if the research fails.
Example: You pay an engineering firm $200,000 to develop a custom component. You own the results and bear the risk if it doesn't work. 65% of $200,000 = $130,000 in QREs.
The Startup Payroll Tax Offset
Companies with less than $5M in gross receipts and in business for 5 years or less can use their R&D credit to offset up to $500,000 per year in payroll taxes. This means pre-profit startups can monetize the credit immediately — no income taxes required.
This benefit was increased from $250K to $500K by the Inflation Reduction Act of 2022 and applies to tax years beginning after December 31, 2022.
How the Credit Is Calculated
Most businesses use the Alternative Simplified Credit (ASC) method. The ASC yields a credit equal to 14% of QREs that exceed 50% of the average QREs from the prior 3 years. For businesses without prior-year QREs, the credit is 6% of current-year QREs.
Simplified example:
Plus up to 3 years retroactive = potentially $168,000+ in total credits already earned.
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