United States: Research And Development Credit Explained

Last Updated: February 15 2017
Article by Bob Croak CPA, MST and Stanley Rose

The federal research and development tax credit represents one of the most powerful ways Congress can encourage innovation. However, it also may represent one of the most underutilized tax breaks, as evidenced by many taxpayers who qualify for its benefits for many years before taking advantage of its savings. This article explains the basics of this credit.


The credit is described in Section 41 of the Internal Revenue Code ("IRC"), and is entitled the "Credit for Increasing Research Activities."

Observation: There is no such thing as the federal "Research and Development" credit or "R&D" tax credit. Those are financial statement terms that originate in Financial Accounting Standards Board language describing segregation of accounting expenses. They are GAAP terms, rather than tax terms. But they are commonly used in describing this credit, and roll off the tongue and keyboard better than the clunky-sounding "Credit for Increasing Research Activities." For that reason, we will unapologetically use the credit's nickname here too.

All of the expenditures that qualify for use in computing the credit first must qualify as deductible expenses. The R&D credit rules simply allow a portion of those deductions to be converted into credits, which are much more potent. (A deduction lowers income that is subject to tax, while a credit lowers tax itself, often dollar-for-dollar.) Paraphrasing IRC Section 41(d), to qualify for the credit, the expenditures must be undertaken for the purpose of discovering information which is technological in nature, 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 related to a new or improved function, performance, reliability or quality.

Qualifying costs do not include costs incurred after commercial production, including adapting an existing product to a customer's need. They also exclude market research, quality control testing, funded research, or research conducted outside of the U.S.

In addition to the above criteria, qualifying costs are further limited to wages and supplies, costs for computer use, and 65% of contractor costs (third parties performing research on behalf of a taxpayer – but only if they, too, do so within the U.S.).

It applies to more than you think

R&D often conjures up a vision of scientists in white lab coats working on a prototype of some entirely new thing no one has ever seen (like, for example, a microwave that you can actually leave a spoon in while reheating your soup, thereby avoiding a small fire and hurtful comments from one's spouse regarding one's memory). However, a new invention is not required for the credit to apply, and operating in a high-tech field is not necessary either. Any type of business might qualify. Often overlooked is the fact that the credit can apply to improvements in processes. Assuming other criteria are met, this could apply to a redesigned layout of a production line that increases performance. One element that appears with regularity in court cases and rulings in this area is that of experimentation, which in turn means that the potential for failure must be present. Generally the outcome must be unknown for the costs related to an undertaking to qualify. However, the credit may be obtained even if a new invention or a patent is not pursued. You do not need to build a better mousetrap; you can instead find a creative way to build the same mousetrap.

It comes in several variants – all of them complex

The amount of the credit is not determined by simply renaming or treating the qualifying costs (or even a portion of them) as a credit. Instead, the computation of the credit involves multiple steps and some specific terminology.

There are three alternative methods of computing the credit.

  1. The "regular" credit works like this: Generally 20% of qualifying costs (described above) over a "base period amount" qualify. The base period amount consists of the average of the most recent four years' revenues multiplied by a "fixed base percentage." The fixed base percentage is derived from a table, but is based on research expenses divided by revenue for a specified number of years. The fixed base percentage cannot exceed 16%, and the base amount must equal at least 50% of the current year's qualified expenses.

    As noted above, credit-eligible costs are also deductible expenses, and the fact that such costs were used to compute the credit does not change that – with one exception. An amount equal to the credit itself must be removed from research expenses for tax purposes (added back to taxable income). The balance of qualifying costs remains deductible. This addback is not required when using the reduced regular credit described below.
  2. The "reduced regular credit" is both an alternative to the regular credit and a subset of it. This credit is computed like the regular credit, but then reduced to equal 65% of the regular credit amount. In exchange, the addback described above that applies to the regular credit is not required. A taxpayer may choose between the regular credit and reduced regular credit on an annual basis, but cannot use an amended return to utilize the reduced credit.
  3. The "alternative simplified credit" is the third and final variant of the credit. Living up to its name, its computation is much simpler than the two regular credits. The credit is equal to 14% of the excess of current year qualified research costs over half of the average costs for the prior 3 years. Taxpayers who do not have qualified costs in one of the prior 3 years receive a credit equal to 6% of current year qualified costs. As is the case with the regular credit (but not the regular reduced credit), the amount of the credit must be added back to current year income. Unlike both of the other methods, once this method is used, it is the only one that can be used for that year and all future years.
Observation: Each of these formulas tends to reward companies whose research expenditures are growing relative to prior years and relative to their revenue (thus, the name Credit for Increasing Research Activities). A company that maintains a steady level of qualifying research costs can expect to see its credit diminish over the years and potentially disappear.

The R&D credit is one of many that are included in an umbrella of credits known as the General Business Credit. Collectively, the credit is limited to offsetting 25% of a taxpayer's regular tax liability exceeding $25,000. Portions unusable due to this requirement can be carried forward for as many as 20 years.

A pair of unique features applies only to small or mid-sized taxpayers, beginning with tax years that start on or after January 1, 2016. The first allows the credit to offset not only regular tax, but also Alternative Minimum Tax (AMT). It applies to certain taxpayers who averaged $50 million or less in gross receipts during the 3-year period preceding the credit. The second allows a portion of the credit to offset payroll tax (FICA). That benefit applies to taxpayers with gross receipts of less than $5 million that generated no revenue in years earlier than the 4-year period preceding the year of the credit. In other words, the ability to offset payroll tax is reserved for small start-ups.


Most, but not all, of the states offer some version of the research credit to offset their income taxes. The types of qualifying costs, calculations, and carryforward periods vary widely. Most are based on research performed within the home state.

The credit's future/conclusion

For decades the R&D credit often expired annually, only to be renewed most years (often retroactively) as part of Congress' year-end "extenders." In spite of the fact that it was allowed to expire so many times, this credit has maintained strong support in Congress, and in 2015 the Path Act finally made the credit permanent. Two competing (but somewhat similar) massive tax overhauls proposed by House republicans and President Trump call for most tax credits to disappear, but the R&D credit is listed in both plans as one of the few credits that will survive.

The credit for increasing research activities truly stands apart from other tax breaks in a number of ways. It is in the country's best interest that we stay on the cutting edge of technological advances and discoveries, and lawmakers have long known that they can influence actions through our pocketbooks. It has broad bipartisan support throughout Washington, and is assured a perpetual life as much as anything in this realm of nonstop tax changes can be. It even enjoys a better than average reputation throughout all but the fringe media. Finally, it benefits a broader range of taxpayers and activities than the casual observer (or even a qualifying, potential participant) might think.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
Ostrow Reisin Berk & Abrams
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Ostrow Reisin Berk & Abrams
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions