The R&D tax credit is a government program that gives money back to companies that develop new products or improve existing ones. In 2025 after Trump’s inauguration, we are not sure if there will be any changes in R&D tax credits, but in 2024 your startup was able to get $500,000 in tax credits for research and development work. This means the government will reduce your tax bill or even give you money back for doing innovative work.
R&D tax credits work differently from other tax benefits because they directly reduce your taxes instead of just lowering your taxable income. For example, if you qualify for a $100,000 R&D credit, you’ll pay $100,000 less in taxes.
Basics of R&D Tax Credits for Startups
Think of tax credits and tax deductions as two different ways to save money. A tax deduction reduces your income before calculating taxes. But a tax credit cuts your taxes after they’re calculated. This makes credits more valuable – a $1,000 credit saves you exactly $1,000, while a $1,000 deduction might only save you $200-300 in actual taxes.
You can get R&D credits at both the federal and state level:
- Federal credits give you up to $500,000 off your payroll taxes
- State credits vary by location (California offers up to 15% of qualifying expenses, while Massachusetts provides up to 10%)
For startups, R&D credits are especially valuable because:
- You can use them to offset payroll taxes, which helps even if you’re not profitable
- You don’t need to pay the credits back
- You can claim them for up to 3 years after doing the R&D work
- The credits work alongside other tax benefits you might qualify for
As of 2024, about 70% of eligible startups don’t claim these credits, often because they don’t know they qualify. Many assume R&D is only for companies with laboratories or scientists, but the definition is much broader and includes software development, product design, and process improvements.
How to qualify for the R&D tax credit
To qualify for R&D tax credits, your startup needs to pass what the IRS calls the “Four-Part Test.” Don’t worry – it’s simpler than it sounds. Here’s what your work needs to include:
The 4-part test
- Technological uncertainty. You must try to solve a technical problem where the solution isn’t obvious. For example: creating a new app feature that hasn’t been done before, finding a way to make your product work faster, developing a more efficient manufacturing process.
- Process of experimentation. You need to show that you tried different approaches to solve your problem. This includes: testing different methods, running prototypes, analyzing test results, making changes based on what you learned.
- Technological in nature. Your work must rely on science, technology, engineering, or math (STEM).
- Qualified Purpose. Your goal must be to create or improve a product, process, software, technique, or formula. The improvement needs to be: related to performance, function, quality, reliability.
Specific eligibility requirements for startups
To claim R&D credits as a startup, you must:
- Have less than $5 million in revenue during the credit year
- Have no revenue before the previous 5 tax years
- Not be a tax-exempt organization
You don’t need to:
- Have a dedicated R&D department
- Succeed in your research
- Create something completely new to the world
Here’s a quick way to check if your work qualifies:
- Are you trying to make something better through technical work?
- Did you have to test different solutions?
- Did you use science or technology?
- Were you trying to improve a product or process?
If you answered “yes” to these questions, your work likely qualifies for R&D credits.
What counts for qualified research expenses (QREs)?
Your biggest qualifying expenses will likely be wages paid to employees who work on R&D activities. You can claim wages for employees who directly perform research, supervise R&D activities, or provide direct support like maintaining test equipment. If an employee spends part of their time on R&D, you can claim that percentage of their wages. For example, if a developer spends 80% of their time creating new features, you can claim 80% of their compensation, including salary, bonuses, and stock compensation.
Contractor costs work slightly differently. You can claim 65% of what you pay contractors for R&D work, but they must perform the work in the U.S., and you must have rights to the research results. For example, if you pay an outside firm $20,000 to help test your new software features, you can claim $13,000 as a qualified expense.
Supplies and materials
You can claim supplies and materials used directly in your R&D work. This includes materials for testing, prototypes, components for test units, and supplies used during experimentation. However, you can’t claim equipment that lasts more than a year, land or buildings, or administrative supplies. Materials used in regular production also don’t count toward your R&D credit.
To support your claims, keep detailed records of employee time spent on R&D, receipts for supplies, and documentation showing how these expenses connect to your research activities. Project plans and test results help prove that your expenses qualify.
For example, if you’re developing a new product, you might spend $70,000 on engineering salaries, $13,000 on outside testing contractors, and $5,000 on prototype materials. Your total qualified research expenses would be $88,000, which forms the basis for calculating your R&D tax credit.
Documentation and Compliance
Proper documentation is critical when claiming R&D tax credits. The IRS may review your claims, so you need clear evidence showing your work qualifies and your expenses are legitimate.
Your documentation should tell the story of your R&D work. Start by keeping project records that show what technical challenges you faced and how you tried to solve them. This includes project plans, technical specifications, test results, and records of design changes.
For employee time, track who worked on R&D projects and what they did. You don’t need complex systems — even basic project management tools or timesheets work if they clearly show R&D activities. Save emails and meeting notes that discuss technical challenges and solutions.
Financial records are equally important. Keep all receipts for supplies and materials used in R&D. For contractor expenses, save contracts and invoices that describe the R&D work performed. Your payroll records should clearly show wages paid to employees working on R&D projects.
Audit protection strategies
If the IRS reviews your R&D credit claim, they’ll look for a clear connection between your documentation and your credit amount. Make this connection obvious by organizing your records around specific R&D projects. Each project should have:
- A description of the technical uncertainty you tried to resolve
- Records showing the process of experimentation
- Documentation of the resources used (people, supplies, contractors)
- Evidence of results, whether successful or not
The most common audit trigger is claiming expenses that don’t clearly connect to R&D work. Avoid this by separating R&D expenses from regular business costs in your accounting system. Also, document your process for determining which activities and expenses qualify for the credit.
Remember that regular business planning or product updates usually don’t count as R&D. Focus your documentation on work that involves technical uncertainty and experimentation. Keep these records for at least four years after claiming the credit.
Another key audit protection strategy is to document your work as it happens, rather than trying to reconstruct it later.
State-level R&D credits for startups
Beyond federal R&D tax credits, many states offer their own R&D incentives. These state credits can significantly increase your total tax savings, and you can often claim them alongside federal credits.
The most generous state R&D programs include:
California offers a 15% credit for qualifying research expenses, with special benefits for startups in certain industries. You can claim this credit even if you’re already claiming federal credits.
Massachusetts provides a 10% credit and allows you to cash out unused credits or carry them forward for 15 years. This is particularly helpful for early-stage companies not yet turning a profit.
Texas companies can get a franchise tax credit of 5% or a sales tax exemption on R&D equipment purchases. You can choose whichever option provides more benefit for your situation.
New York offers several R&D incentives, including credits for emerging technology companies and facilities. Their program specifically targets growing startups in fields like software and biotechnology.
When claiming state credits, remember that:
- Each state defines qualifying research differently
- Application deadlines and processes vary by state
- Some states let you sell or transfer unused credits
- Documentation requirements may differ from federal rules
Get expert help with your R&D tax credits
While claiming R&D tax credits can be complex, companies like FI Group specialize in helping startups understand and claim these benefits at both federal and state levels. With two decades of experience in innovation tax incentives, their services include identifying qualifying R&D activities, ensuring proper documentation, managing compliance requirements, and preparing for potential audits.
Startups interested in exploring their R&D tax credit eligibility can request an initial assessment from FI Group or similar consultancies to better understand their potential benefits.
