The research credit is calculated from qualified research expenses, usually shortened to QREs. Only three categories of cost count: wages, supplies and 65% of contract research costs, each linked to the qualifying work. Everything the credit is worth flows from how carefully those three categories are measured, so this page takes each in turn, then lists what is left out.
Cost categories that qualify
| Category | What it covers | Amount that counts |
|---|---|---|
| In-house wages | Wages paid to employees for performing, directly supervising or directly supporting qualified research | The part of wages attributable to qualified services |
| Supplies | Tangible property used in the conduct of qualified research, other than land, depreciable property and improvements to either | Cost of supplies consumed in the research |
| Contract research | Amounts paid to a third party for qualified research performed on the taxpayer's behalf | 65% of the amount paid |
| Computer rental | Amounts paid for the right to use computers in the conduct of qualified research, which in practice includes cloud computing capacity | The amount paid, treated as in-house research expense |
The first three categories are stated in section 41(b). The fourth, amounts paid for the right to use computers, is also in the statute and is how cloud hosting and compute used in development enters a claim. A separate category, basic research payments to universities and certain research organisations, earns a different credit and is covered by the Form 6765 page.
Staff and time
Wages are the largest category in most claims. Three kinds of activity count as qualified services: engaging in qualified research, directly supervising it, and directly supporting it. Direct supervision is the immediate supervision of the people doing the research, typically a first-line engineering manager, not the whole chain above them. Direct support is work such as building a prototype or running a test rig under a researcher's direction, not general administration.
The wage figure is the amount reported for federal income tax withholding, which means it includes bonuses and stock compensation included in taxable wages but not employer benefits or payroll taxes. Where an employee splits time, the claim takes the proportion of wages that matches the proportion of time on qualified services, so the method of allocating time is the foundation of the claim. The regulations give a concession worth knowing: if substantially all of an employee's services during the year are qualified services, meaning 80% or more, the whole of the wages can be treated as qualified.
| Role | Qualified services? | Typical allocation basis |
|---|---|---|
| Development engineer | Yes, when working on qualifying projects | Project time records |
| Engineering manager who reviews designs daily | Yes, as direct supervision | Time spent on qualifying projects |
| Vice president of engineering | Usually no, unless personally supervising or performing research | Excluded, or a documented minority share |
| Technician building test rigs | Yes, as direct support | Project time records |
| Finance, HR, sales | No | Excluded |
Contractors and subcontracted work
Contract research expenses are amounts paid to a person other than an employee for qualified research performed on the taxpayer's behalf, and 65% of the amount paid counts. The contractor's work must itself be qualified research, must be performed in the United States, and the taxpayer must bear the economic risk and retain substantial rights in the results, otherwise the arrangement is funded research from the contractor's side and excluded from the taxpayer's side. The regulations also require that the agreement is entered into before the research is performed and that the payment is for the performance of research rather than for a product or result. Two higher percentages exist: 75% for amounts paid to a qualified research consortium and 100% for certain payments to eligible small businesses, universities and federal laboratories for energy research.
Staffing agency workers are a common question. Payments to a staffing firm for workers who are not the taxpayer's employees are generally treated as contract research expenses, subject to the 65 percent limit, rather than wages (Treasury Regulation 1.41-2(e)), even though the person sits in the taxpayer's office.
Materials, software and overheads
Supplies are tangible property used in the conduct of qualified research, excluding land, depreciable property and improvements to either. Prototype materials, consumables in a test programme and raw materials destroyed in trials all count. The machine that runs the trial does not, because it is depreciable. Extraordinary utilities used in research can count, ordinary heating and lighting cannot.
Software bought for the development team is depreciable or amortisable property, so its cost is not a supply. Cloud compute, by contrast, is a payment for the right to use computers and counts in full when used in the conduct of qualified research. Overheads of every other kind, rent, insurance, depreciation, travel, training and general and administrative costs, are outside the credit entirely, which is one reason the federal credit is narrower than the section 174 deduction.
Costs that are excluded
- Employer payroll taxes and benefits, because wages are measured by the withholding definition.
- Depreciation, equipment and capital purchases, including software licences and laboratory equipment.
- Rent, utilities (except extraordinary research utilities), travel, training and general overhead.
- 35% of every contract research payment, and 100% of payments for research performed outside the United States.
- Wages for work on excluded activities: post-production support, adaptation, surveys, foreign research and funded research.
- Costs reimbursed by a customer or grant where the taxpayer did not bear the economic risk.
Illustrative example
Halvern Analytics, a hypothetical software company, has the following costs on a qualifying project in a year.
| Cost | Amount | Treatment | QRE |
|---|---|---|---|
| Four engineers, 100% on the project | US$600,000 wages | Qualified services, substantially all | US$600,000 |
| Engineering manager, 50% supervising the project | US$180,000 wages | Direct supervision, allocated | US$90,000 |
| Employer payroll taxes and benefits | US$156,000 | Not wages under the withholding definition | 0 |
| US contractor performing load testing | US$100,000 | Contract research, 65% | US$65,000 |
| Cloud compute for test environments | US$40,000 | Right to use computers | US$40,000 |
| Laptops and software licences | US$30,000 | Depreciable property | 0 |
| Office rent allocated to the team | US$60,000 | Overhead | 0 |
| Total | US$1,166,000 | US$795,000 |
Roughly two thirds of the project's cost becomes QREs. The credit is then a percentage of the QREs above a base amount, which the calculation method page explains.
Related pages
Official sources
Educational content only, not tax advice. See the disclaimer.