About six months ago I picked up a new client, a machine shop up in Northern Kentucky that did custom tooling and fixtures. They were making about $8 million a year in revenue, and they had been with their previous accountant for over five years. The previous accountant had never mentioned looking at an R&D credit or doing an R&D study. Not because he was necessarily a bad CPA. It's just not commonly thought of that a machine shop would be eligible for the R&D credit.
We did the study and went back three years, which is all that's allowed by law, and ended up getting him $127,000 in R&D credits.
People hear the R&D label and they think software, pharma, huge billion dollar budgets. But it's way broader than people think. Congress wrote it that way on purpose. If you're developing products, testing processes, writing software, or solving any sort of technical problems through trial and error, you probably qualify. Most businesses that don't think they're doing R&D are likely doing R&D. It's actually a lot more common in the restaurant space than anybody would ever think of.
The Four Part Test
There's a four part test that the IRS has that you need to satisfy to qualify for the credits. Permitted purpose. Technological in nature. Elimination of uncertainty. Process of experimentation. All four have to be met or the whole thing falls apart.
Permitted purpose means you have to develop a new or improve an existing product, process, software, formula, or invention. For most small businesses it's going to be the improving of what you already have that satisfies this test.
Technological in nature. Not necessarily using computers or technology in the way people think of it. It just has to rely on hard science, engineering, computer science, biology, physics.
Elimination of uncertainty means you're trying to figure out whether something works, how to make it work, what the right process or design is. It's got to be something you don't know that you figure out.
And you have to test several ways of doing it. You know you have a problem, you try four different solutions. You're experimenting between alternatives and eliminating options. It doesn't have to be successful to get the credit. If the experiments fail, it still qualifies, so keep that in mind.
What Expenses Qualify
Your expenses basically fall into three different categories: wages, supplies, and contract research. Meaning people that you employ, materials you use, and people that you pay who are not employees.
Wages are basically broken down by time spent. You actually have to track the hours. It's going to be a percentage allocation, so you're going to want to maintain time logs for tracking wages. If your engineer spends half his time on production and half on developing a new process, you need documentation showing that split.
Supplies must be directly consumed in the project, and you have to be able to trace them directly to the project. Any materials used or wasted during the experimentation process are fair game.
Contract research, you're only getting about 65 cents on the dollar on what you pay subs or outside contractors. And all contract research has to be US based. Foreign labor and foreign subs don't count toward the credit.
What the IRS Says No To
The IRS has a specific list of exclusions, and there is no leeway when it comes to them.
If it's funded by an outside grant, it does not count. The data collection process or surveying potential clients does not count. QC, routine product testing, does not count. Reverse engineering someone else's product does not count. Custom building a project for a specific customer does not count. Research after your production starts does not count. It has to be prior to production.
Any work done by your subcontractors has to be US based. You can't use foreign labor or foreign subs.
What Changed in 2025
The One Big Beautiful Bill Act signed July 4, 2025 killed some of the debilitating rules for small businesses and startups, specifically the capitalizing of R&D expenses. You used to have to capitalize them over 60 months and then amortize them for five years, so you'd get one fifth of the deduction for the next five years. If you were a startup, that could end up actually costing you large amounts of money in tax that didn't even offset the credits. That got killed. Immediate expensing is back, it's permanent, and it's retroactive. If you amortized R&E costs from 2022 through 2025, talk to your CPA about filing amended returns.
The payroll tax credit cap doubled from $250,000 to $500,000. Startups with no taxable income can offset their FICA on their 941s, which is huge because they don't have revenue. It's straight burn that dramatically reduces their burn rate and increases their runway.
There are new reporting requirements on the 6765 under Section G, but those are optional until 2026. Exceptions include qualifying research expenses under $1.5 million and gross receipts under $50 million, or if you're taking the payroll election.
How the Credit Math Works
For most businesses, they use the Alternative Simplified Credit, which is the qualifying research expenses less 50% of your three year average of the qualifying research expenses, times 14%.
Say you spend $500,000 this year, but your previous three year average was $400,000. Half of that $400,000 is $200,000, so $500,000 minus $200,000 is $300,000, and you get 14% of $300,000. That's a $42,000 credit.
That credit needs to be deducted from your qualifying expenses, but you still get to deduct the expenses and then get the credit on top. The $500,000 spent less the $42,000 credit is $458,000 deductible. At the top pass through rate of 29.6% that's about $135,500 in tax savings from the deduction, plus the $42,000 credit gets you to about $177,500 in total benefit. Pretty different from just taking the deduction alone.
Documentation
The IRS is definitely scrutinizing R&D credits more now. You need employee time logs. Invoices from your contractors detailing what research work was done. Support from your employees, like meeting notes, emails, and specifics on the testing.
I would have project documents explaining the technical uncertainty, the various ways you were attempting to resolve it, what was successful, what was not.
You have to have a series of documentation, or you will lose. Write it down while you're doing it. Trying to recreate records two years later for an audit is expensive, painful, and the examiner is never going to buy it.
Industries That Qualify
There are some industries that qualify that most people wouldn't think of.
Software is a huge one, especially startups. They pretty much always qualify.
Food and beverage and restaurants, especially higher end fine dining restaurants that change menus a lot.
Manufacturing, especially with process improvement or redesigning manufacturing methods, because manufacturers are always trying to gain a few percent in efficiencies.
Agriculture is a big one as well, especially regenerative agriculture, regenerative farming, because it's a huge testing process.
None of them have R&D budgets, but they all do processes that qualify for R&D.
Common Mistakes
Ignoring it. Most people don't think about it, but it's something they're doing anyway, so they're just leaving free money on the table.
Not properly documenting it. This is a big one for people who don't plan for it, like if you try to go back and recreate the records but don't have proper documentation. You're making big mistakes.
Not checking the payroll election for a lot of small businesses. You should definitely run both calculations and see if it's worth your time.
Don't forget about the outside contractors or contract research. That's often overlooked, forgotten about.
Where to Start
You want to look at your departments and see where you solve technical problems or build anything new. You figure out your activities, and then you pull together your qualifying research expenses. You can amend back three years. It's a lot of work, but it's definitely worth the money. If you make an effort and build a process that going forward gives you proper documentation, it saves you a lot of time.
You want to talk to a CPA who knows Section 41 and can help you put together documentation that holds together under an audit.
