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As a small business owner, you may feel overwhelmed by the complexity of R&D Capitalization, especially since the recent tax law changes. The 4-Part Test, for determining what qualifies as R&D expenses, seems especially daunting. The good news is that you don't have to face it alone. This article will break down the 4-Part Test for R&D Credit and help you understand how to navigate this process to maximize your tax credits.
Haven's accounting services for small businesses are designed to help you achieve your objectives, like learning about how the 4 Part Test for R&D Credit may apply to you. Let us help you simplify the process so you can focus on what matters most: your business.
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What is the 4-Part Test for R&D Credit?
To qualify for the U.S. Research and Development (R&D) Tax Credit, businesses must prove that their research activities meet all four parts of the IRS’s qualification criteria, commonly known as the 4-Part Test. This test is designed to ensure that only legitimate, innovation-driven work receives the tax benefit.
Here’s a breakdown of each component of the 4-Part Test:
Section 174 Test: Qualified Research Expenses
This test determines whether an activity qualifies under Section 174 of the Internal Revenue Code, which governs R&D expenses.
To meet the criteria, the work must:
Be undertaken as part of your trade or business
Incur costs of an experimental or laboratory nature
Aim to eliminate technological uncertainty
In simpler terms, your project should involve solving a problem without a clear path forward. You’re unsure how to achieve the result, whether it’s feasible, or which design or method will work best. Crucially, success isn’t required. The focus is on the nature of the activity, not whether the final product reaches the market.
Technological in Nature Test
The research must rely on hard sciences.
Specifically, it must involve:
Physical sciences
Biological sciences
Engineering
Computer science
Activities that are artistic, stylistic, or based on social sciences (like market research or customer preference studies) do not qualify. This test ensures the innovation is grounded in technical disciplines rather than creative or business strategy.
Business Component Test
To qualify, the R&D must aim to develop or improve a “business component.”
A business component is broadly defined and includes:
A product.
A process.
A technique.
An invention.
A formula.
Or software.
The key point here is intent:
The company must plan to hold the component for sale, lease, license, or use in its business. So, even internal process improvements can qualify, if they’re used in the operation of the company.
Process of Experimentation Test
This is arguably the most technical and misunderstood part of the test. The company must use a systematic process to evaluate one or more alternatives to achieve a result where the capability, method, or design is initially uncertain.
Key aspects of this test include:
Substantially all (i.e., 80% or more) of the R&D effort must involve this experimental process.
It must involve trial and error, testing, modeling, prototyping, or similar methods.
The goal is to resolve uncertainty through a structured investigation, rather than relying on guesswork.
This ensures the work is not just routine problem-solving or general product development, but rather something that tests and evaluates alternatives scientifically or technically.
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Application of the 4-Part Test to Software Development
Permitted Purpose
The first requirement assesses whether the project seeks to create or improve a product, process, or software functionality. In software development, this is often met when building a new application or making substantial enhancements to existing platforms.
For example, developing version 1.0 of a web app qualifies, but so does upgrading to versions 2.0 or 3.0, provided the work introduces:
New capabilities
Integrations
Performance improvements
Because software evolves continuously, companies can often meet this criterion throughout the product lifecycle.
Technical Uncertainty
To meet this requirement, the developer must attempt to resolve uncertainties related to functionality, performance, or system integration.
Technical uncertainty exists when the team doesn’t initially know how to:
Implement a feature
Scale the system
Ensure compatibility
Most software projects involve problem-solving without clear answers from the start. For instance, the team might be unsure which data model will support scalability or whether a new algorithm can meet required performance benchmarks.
Process of Experimentation
Software development typically involves iterative design and testing, which aligns with the requirement for a process of experimentation. Teams often explore multiple approaches to architecture, user interface, or performance optimisation, refining their solutions based on outcomes.
Agile, Scrum, and other software development life cycle (SDLC) frameworks naturally incorporate trial-and-error, through:
Sprints
Prototypes
User feedback
QA cycles
These structured activities meet the Internal Revenue Service (IRS) definition of experimentation.
Technological in Nature
This test requires that the activity be rooted in hard sciences, such as engineering or computer science. Since software development is fundamentally built on computer science principles, this requirement is typically met without issue. Activities such as algorithm development, database structuring, API integration, or system security improvements are all examples of tasks that fulfill this criterion.
Internal Use Software (IUS) and the High Threshold of Innovation
When software is developed for internal business use, rather than for sale or external deployment, it must also satisfy a High Threshold of Innovation, which includes an additional three-part test:
Innovation Test: The software must be unique or significantly different from existing solutions.
Economic Risk Test: The company must invest substantial resources with no guaranteed return, facing real technical and financial risk.
Commercial Availability Test: No off-the-shelf software can perform the required function without significant customisation.
This test ensures that businesses are not claiming routine IT expenses, but are rewarded for truly innovative and high-risk internal development initiatives.
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R&D Tax Credit Calculation Options
The method you choose directly impacts the amount of credit you can claim, so selecting the right one is essential to maximising your benefit. Taxpayers can calculate the R&D tax credit using one of two methods:
Regular Research Credit (RRC) Method
The Regular Research Credit (RRC) method allows businesses to claim 20% of qualified research expenses (QREs) that exceed a calculated base amount. The base amount is determined by multiplying a fixed-base percentage by the average gross receipts from the previous four years.
Here’s how it works:
Determine the fixed-base percentage:
Divide the total QREs from the past four years by the total gross receipts for the same period.
Use the lesser of this percentage or 16%.
Calculate the base amount:
Multiply the fixed-base percentage by the average annual gross receipts from the past four years.
Apply the minimum base rule:
The base amount must be at least 50% of the current year’s QREs. If not, use 50% of the current QREs as the base.
Calculate the credit:
Subtract the base amount from the current year’s QREs.
Multiply the difference by 20% to determine the credit.
The RRC method can be complicated for new businesses or those without at least four years of historical data. In such cases, the Alternative Simplified Credit (ASC) method is often a more practical option.
Alternative Simplified Credit (ASC) Method
The Alternative Simplified Credit (ASC) method provides a more accessible and simplified approach to claiming the R&D tax credit. While it generally results in a lower credit percentage compared to the regular process, it’s a practical option for businesses without four years of historical data.
Here’s how it’s calculated:
Determine the average QREs for the past three years.
Multiply that average by 50%.
Subtract the result from the current year’s QREs.
Multiply the difference by 14% to calculate the credit.
If the company has no QREs in any of the past three years, the credit equals 6% of the current year's QREs.
R&D Credit for Payroll Tax Offset
Eligible businesses can apply up to $250,000 of the R&D tax credit against employer Social Security payroll tax liabilities.
To qualify:
The business must have less than $5 million in gross receipts for the current year, and
Must be within its first five years of generating gross receipts.
Electing a Reduced Credit
Businesses using either calculation method may choose to elect a reduced credit under Section 280C. This election reduces the credit amount but avoids increasing taxable income, which can be beneficial if the full credit would cause the company to be taxed at a higher rate.
S corporations nearing a higher bracket may benefit from taking the reduced credit.
C corporations, which are taxed at a flat rate, typically have no incentive to reduce the credit.
State R&D Tax Credits
In addition to the federal credit, many states offer research and development (R&D) tax incentives. These vary by jurisdiction, so understanding your state’s specific regulations is key to maximising your overall tax savings.
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How to Claim R&D Tax Credits
To qualify for the R&D tax credit, businesses must meet the criteria set out in IRS Section 41.
This includes:
Developing or improving products, processes, or software.
Relying on hard sciences such as engineering, computer science, or biology.
Addressing technical uncertainty through a process of experimentation.
Performing the development in-house.
Importantly, the credit is not limited to any one industry. It applies broadly across various sectors, including manufacturing, software, biotechnology, architecture, and others.
What Expenses Qualify for R&D Tax Credits?
The IRS requires adequate documentation of all research activities and related expenses to support an R&D tax credit claim.
Qualified expenses generally fall into four main categories:
Wages paid to employees directly involved in qualified R&D activities
Supplies used in the research process (excluding capital assets)
Contractor costs, covering up to 65% of the qualified work performed by third parties
Cloud computing expenses related to development, testing, or hosting during R&D
Acceptable documentation may include payroll records, time-tracking logs, technical reports, design sketches, project notes, and even oral testimony, though contemporaneous written records are strongly preferred to substantiate claims.
How to Claim R&D Tax Credits
Form 6765, Credit for Increasing Research Activities, is used to claim the federal R&D tax credit formally.
The form is divided into four sections, not all of which apply to every business:
Section A – Regular Credit: Use this section if you’re applying the traditional calculation method. Key lines include 1, 2, 3, 7, 8, 10, 11, and 17.
Section B – Alternative Simplified Credit (ASC): For businesses using the simplified method. This option is often easier and can be more favourable if your R&D spending hasn’t consistently increased over time.
Section C – Business Structure Information: Captures details about your legal entity (e.g., S corporation, partnership) to help the IRS properly link your credit to other required forms and schedules.
Section D – Payroll Tax Offset for Qualified Small Businesses (QSBs): If your business has less than $5 million in gross receipts and is within five years of starting up, this section allows you to apply the credit against employer payroll taxes instead of income tax.
Choose the Most Beneficial Calculation Method
The IRS recommends calculating the R&D tax credit using both Section A (regular method) and Section B (ASC) to see which gives you the greater benefit. Then, submit the section that maximizes your credit.
File for R&D Tax Credits With Your Tax Return
Form 6765 should be submitted along with your business income tax return, such as Form 1120 for corporations or Form 1065 for partnerships. If you’re claiming the payroll tax offset as a Qualified Small Business, be sure to coordinate the credit with your quarterly payroll tax filings on Form 941. Proper alignment between your income tax return and payroll filings is essential to ensure the credit is applied correctly.
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R&D Tax Credits for Architects
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Let your business take flight while Haven manages your financial runway. Built by founders for founders, we handle everything from daily bookkeeping to complex tax filings and R&D credits that put cash back in your pocket, as well as fractional CFO services.
Join 400+ startups who've saved millions in tax credits, countless hours of administrative work, and never missed a filing deadline, all while accessing 24/7 Slack support from CPAs who understand the unique challenges of growing businesses. Book a call today and discover how our dedicated team can help you focus on building rather than bookkeeping.