The four-part test for the R&D tax credit

The statute in one sentence

26 U.S.C. 41(d)(1)

The term "qualified research" means research:

with respect to which expenditures are treated as domestic research or experimental expenditures under section 174A,

which is undertaken for the purpose of discovering information (i) which is technological in nature, and (ii) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and

substantially all of the activities of which constitute elements of a process of experimentation for a purpose described in paragraph (3).

Internal Revenue Code, section 41(d)(1)

The same test, in plain English

Four questions

Were you making or improving something you sell or use?The law calls it a "business component."
Did it take real know-how to make it work?"Technological in nature": engineering, physics, chemistry, biology, or code.
Were you unsure how to do it at the start?"Technical uncertainty."
Did you try options to find out?A "process of experimentation."

Each part below starts with the law's words, then says what they mean. Where it shows up by trade: what qualifies.

Something new or improved

Part one · business component

A business component is "any product, process, computer software, technique, formula, or invention which is to be (i) held for sale, lease, or license, or (ii) used by the taxpayer in a trade or business of the taxpayer." The research must be intended to produce "a new or improved function, performance, or reliability or quality," and it is never treated as qualifying "if it relates to style, taste, cosmetic, or seasonal design factors."
Section 41(d)(2)(B) and 41(d)(3)

01

Better at one thing is enough

Work that makes something function, perform, last, or hold quality better clears this part. Looks alone don't: a redesign for style stays out.

02

It's usually what you deliver

For an architect, the drawing set. For an integrator, the system built for one client's space. For a practice, the protocol that brings a new device into care.

03

Each project is tested on its own

Twenty projects in a year means twenty separate tests. A Foundry R&D credit study claims the ones that pass.

04

If the whole fails, a part can pass

When a full product doesn't qualify, the rules check its most significant subset of parts, then the next, until a part passes. A production line counts as its own component, apart from what it makes.

It took real know-how

Part two · technological in nature

"Information is technological in nature if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science."
Treasury Regulation 1.41-4(a)(4)

01

Science you can measure

The work has to rest on engineering, physics, chemistry, biology, or computer science. Sizing a beam counts. So does programming a controller or testing a new resin.

02

Marketing and management don't count

The law leaves out the social sciences, arts, and humanities. Market research is real work, just not this kind.

03

Usually the easiest part

In most trades the science is already in the work. The study names it and ties each project's open question to it.

04

It doesn't have to be new to the world

The rules say you don't need to go past what skilled people in your field already know ("exceeds, expands or refines the common knowledge"). A patent helps as evidence but isn't required.

You weren't sure how at the start

Part three · technical uncertainty

"Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the business component, or the appropriate design of the business component."
Treasury Regulation 1.41-4(a)(3)

01

Any one of three doubts

Can it be done at all? How should it be done? What should the finished design be? Many projects carry the last one: the information on hand doesn't settle the right design until it is worked out.

02

Permits and budgets don't count

A slow permit or a moving budget makes a job hard, but not in a way the test counts. It asks technical questions: how a structure carries its load, how a custom orthotic should be shaped.

03

The first one carries the most

Design your first custom home and the unknowns are real. Design three more like it and each has fewer. The study claims the work that was new to you.

04

Hard cases are where the time counts

Standard cases are settled work. The patients and sites the usual approach doesn't fit are where the unknowns are. If they're a fifth of the year, roughly a fifth of the time can count.

You tried options to find out

Part four · process of experimentation

"A process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer's research activities." The requirement is met when "80 percent or more of a taxpayer's research activities, measured on a cost or other consistently applied reasonable basis," are elements of that process, and it "does not require that the taxpayer succeed."
Treasury Regulation 1.41-4(a)(3)(ii), (a)(5), and (a)(6) and section 41(d)(1)(C)

01

Trying one answer against another

Redlines and calculations for an architect. Bench tests and on-site problem solving for an integrator. Fitting and refitting for a practice.

02

Failure still counts

A prototype that didn't work or a design you dropped is proof you experimented. The rules say so outright.

03

"Substantially all" means 80 percent

At least four fifths of the work on a component has to be this kind of testing, measured by cost or another steady method. The rest can ride along in the claim, as long as it isn't excluded work such as production after the design is settled.

04

It ends when it's ready to sell

Once a component is ready for sale or regular use, the experiment is over. Work after that is production, and the law excludes it by name.

What the law rules out

Section 41(d)(4)

Research after commercial productionOnce the component is ready for sale or use, the work that follows is production.
Adaptation of an existing componentFitting an existing product or process to one customer's needs, without technical change, is service rather than research.
DuplicationReproducing an existing component from its physical examination or from plans is not development.
Surveys, studies, and routine testingEfficiency surveys, management activities, market research, routine data collection, and routine quality control testing stay out. Testing that evaluates alternatives during development is a different thing, and it counts.
Software built only for internal useSoftware your business runs on, rather than sells, faces an added set of requirements before it qualifies.
Foreign researchOnly work performed in the United States, Puerto Rico, or a United States possession counts. Where the work happens governs, not where the business is registered.
Social sciences, arts, and humanitiesThe second part of the test, restated as an exclusion.
Funded researchWork that another party paid for, judged by who bears the financial risk and who keeps the rights. The next section takes this one apart.

Who holds the credit on contract work

Funded research

01

Risk decides it

The question is who would lose money if the work failed. If you get paid only when the work succeeds, the risk is yours. If the client pays whether or not it succeeds, as with hourly billing or fees paid on milestones regardless of the outcome, the work is funded and the risk sits with them. The contract language decides it, not the label on the fee.

02

Rights matter too

The party that keeps substantial rights to the results is the party that can claim. Many professional-services contracts leave those rights with the firm that did the work. The study confirms it contract by contract.

What costs count

Section 41(b)

Qualified research expenses are "in-house research expenses" and "contract research expenses." In-house expenses are "any wages paid or incurred to an employee for qualified services," "any amount paid or incurred for supplies used in the conduct of qualified research," and "any amount paid or incurred to another person for the right to use computers in the conduct of qualified research." Qualified services are "engaging in qualified research, or engaging in the direct supervision or direct support of research activities which constitute qualified research."
Section 41(b)(1) and 41(b)(2)

01

Wages come first

The people doing the work, plus the people directly supervising or supporting it. A principal reviewing redlines counts. So does a physician assistant recording a procedure. Front-office staff don't.

02

The 80 percent rule for people

Someone who spends 80 percent or more of the year on qualifying work counts in full.

03

Supplies and computing

Materials used up in testing, including prototypes that never shipped, and cloud computing used to run the tests. Equipment you depreciate isn't a supply.

04

Contractors at 65 percent

The statute counts 65 percent of what you pay an outside party for qualified research performed in the United States, provided you pay whether or not the research succeeds and it is done on your behalf.

What the record has to show

Substantiation

01

Usable form and detail

The regulations require records kept "in sufficiently usable form and detail to substantiate" the expenses claimed. They do not prescribe a format, and they do not require hour-by-hour time tracking.

02

The evidence you already keep

Drawings, redlines, change orders, test results, fabrication logs, and follow-up notes tie each project to the four parts. Interviews with the people who did the work produce reasonable estimates of time, checked against what a firm like yours would plausibly spend.

The study is that record, written for an examiner before one ever calls.

Common questions

Does the work have to succeed?

No. The regulations state that qualifying "does not require that the taxpayer succeed in developing a new or improved business component." The attempt is what the test measures.

Does it have to be new to the world, or patentable?

No. The standard is new to your company. The regulations say the research need not exceed the common knowledge of skilled professionals in the field, and a patent is evidence rather than a requirement.

What does "substantially all" mean?

At least 80 percent of the activities on a business component, measured by cost or another consistently applied basis, have to be elements of a process of experimentation.

What if only part of a project qualifies?

The regulations shrink the test back to the most significant subsystem that passes, so a qualifying part of a larger product can be claimed on its own.

Do permits, approvals, and budgets count as uncertainty?

No. They are administrative uncertainty. The test asks about capability and method, and about the appropriate design. Those are technical questions.

Does routine testing count?

Routine quality control and routine data collection are excluded by statute. Testing that evaluates one alternative against another during development is experimentation, and it counts.

Our customer paid for the project. Whose credit is it?

It depends on the contract. If your payment depends on the work succeeding and you keep substantial rights to the result, the credit is yours. If you get paid either way, the work is funded and you can't claim it.

Does the test change for a small practice or a one-person firm?

No. The test is applied to each business component regardless of the size of the business. Smaller firms produce smaller credits, and the credit grows as the work does.

Where does the four-part test come from?

Section 41(d) of the Internal Revenue Code and the Treasury regulations under it, chiefly regulation 1.41-4. The statute names the requirements; the regulations define uncertainty, technological in nature, and the process of experimentation.