The "Substantially All" Rule
In the context of the US R&D Tax Credit, understanding the 80% Threshold is critical for maximizing returns and ensuring compliance.
The Meaning
The "Substantially All" rule is a provision within IRS regulations (specifically Treasury Regulation § 1.41-4(a)(6)) stating that if substantially all (defined as 80% or more) of a taxpayer's activities constitute qualified research, then 100% of the expenses associated with that activity may be eligible for the credit. Conversely, if the activities fall below this threshold, only the portion directly attributable to qualified research can be claimed.
The Importance
This rule is a powerful lever for efficiency. It simplifies record-keeping for highly technical roles by allowing companies to claim an employee's full salary without tracking every minute, provided they meet the 80% test. It prevents the administrative burden of segregating small fractions of non-qualified time (like general meetings) for staff who are primarily dedicated to R&D.
Interactive Threshold Simulator
This interactive tool demonstrates the "cliff effect" of the Substantially All rule. Adjust the slider below to simulate the percentage of an employee's time spent on Qualified Research Activities (QRA). Observe how the Claimable Expense behaves when you cross the critical 80% line. This illustrates why documenting that extra percentage point can significantly impact your tax benefit.
Case Study: The "Shrink-Back" Nuance
What happens if you don't hit 80%? You don't lose everything. The "Shrink-Back" rule applies, meaning you can still claim the portion of expenses that were qualified. Compare the two scenarios below to understand the difference between the "All" outcome and the "Allocation" outcome.
Scenario A: The Senior Developer
Salary: $150,000 | QRA Time: 85%
Result: Since 85% > 80%, the Substantially All rule applies.
Claimable Base: $150,000 (100%)
Scenario B: The Project Manager
Salary: $150,000 | QRA Time: 60%
Result: Since 60% < 80%, only actual QRA is claimed.
Claimable Base: $90,000 (60%)
Next Steps: Clarifying Your Position
To effectively utilize the Substantially All rule, meticulous documentation is required. Use the interactive checklist below to audit your current R&D tax credit readiness.
Reviewing these steps with a qualified tax professional is recommended to ensure compliance with specific jurisdictional regulations.
Navigating the Substantially All Rule: Compliance, Optimization, and Audit Defense under IRC Section 41
The Substantially All Rule (SAR) represents a foundational quantification within the R&D Tax Credit framework under Internal Revenue Code (IRC) Section 41. It establishes a precise regulatory threshold, defining “substantially all” as at least 80 percent ($\geq 80\%$) of activities or services.1 This precise percentage governs the eligibility of expenditures claimed as Qualified Research Expenditures (QREs) across two key, distinct applications: the services performed by an employee (wages) and the overall research activities associated with a defined business component (the project).2 For both applications, the rule often dictates an “all-or-nothing” result: meeting the $80\%$ threshold allows a taxpayer to claim $100\%$ of the related expense or component, whereas failing the threshold either limits the claim or, in the case of a business component, can result in complete disallowance if mitigation rules are not applied.2
The importance of the SAR is paramount because it acts as both a primary maximization tool for taxpayers and, increasingly, a stringent gateway used by the Internal Revenue Service (IRS) to vet and potentially disallow research credit claims.3 Historically, firms utilized the SAR to ensure the full inclusion of high-wage R&D personnel and to support broadly defined projects. However, the current regulatory environment features heightened scrutiny, with the IRS actively challenging the application of the rule, particularly concerning the requirement that 80% or more of research activities for a business component must constitute a process of experimentation, as mandated under IRC Section 41(d)(1).3 This shift toward adversarial enforcement, evidenced in recent tax court decisions like Intermountain Electronics v. Commissioner 3, transforms the accurate application and robust documentation of the SAR from a mere optimization strategy into a core, necessary compliance requirement for audit defense and risk mitigation.
I. The Dual Nature of the Substantially All Test
The rigorous application of the Substantially All Rule requires a detailed understanding of its operation across two distinct areas of R&D credit qualification. The complexities arise primarily from the differing bases used for calculation (time versus cost) and the potential for the IRS to leverage the rule to disallow claims, rather than merely adjusting them.3
A. Substantially All Rule for Wages (Qualified Research Expenditures)
The first, and often simpler, application of the SAR pertains to qualified research expenses related to wages. This test is applied on an employee-by-employee basis.5 If an employee performs services where $80\%$ or more of their annual work time fits the criteria of qualified research, then all of that employee’s annual wages are eligible as QREs.1
If the calculated ratio falls below the 80% threshold, the rule transitions from an “all-or-nothing” inclusion to a pro-rata inclusion: only the portion of the wages strictly attributable to qualified activities may be claimed.2 The computational framework established under Treasury Regulation section 1.41-2(d) determines this percentage by using a fraction: the numerator consists of hours spent in the conduct of qualified services, and the denominator comprises the total hours spent in the conduct of all services. Notably, non-service time, such as sick leave, is explicitly excluded from the denominator.5
Judicial Clarification and Strategic Optimization
The determination of what constitutes “qualified services” in the numerator received crucial clarification from the U.S. Court of Appeals for the Seventh Circuit in the 2023 opinion Little Sandy Coal v. Commissioner.6 The appellate court affirmed that costs associated with direct support and direct supervision of research activities qualify for inclusion in both the numerator (qualified services) and the denominator (total services) of the 80% calculation, provided those costs qualify as “research expenses” deductible under Section 174 of the Internal Revenue Code.6
This judicial finding provides a critical pathway for compliance optimization. If a high-wage supervisory engineer dedicates 70% of their time to hands-on qualified research and 15% to direct supervision of those activities, their total qualified time is 85%, thereby easily meeting the $80\%$ threshold. Had the supervisory time been excluded from the numerator, the employee would have failed the test, leading to a substantial reduction in the claimable QRE base. Therefore, organizations must ensure their time-tracking systems are granular enough to categorize and document supervisory and direct support time separately from general administrative or non-R&D management time, effectively utilizing this case law to maximize QREs for senior technical personnel.
The Imperative for Documentation
The regulatory consequences of missing the 80% threshold are significant, creating a substantial financial multiplier effect. For an employee whose time is documented at 79% R&D, only 79% of their wages may be claimed as QREs; had the documentation reached 80%, 100% of the wages would be claimed.2 The cost of failing the SAR by just one percentage point is the immediate loss of $21\%$ of that employee’s wages from the QRE base. This stark multiplier effect necessitates a high investment in precise, contemporaneous recordkeeping systems. The IRS explicitly demands detailed documentation during audits, listing payroll records, specific employee job descriptions, performance evaluations, calendars, and appointment books as essential sources for verifying claimed QREs.1
The following framework summarizes the computational rules for the wage SAR, incorporating the Little Sandy Coal precedent:
Table Title: Computational Framework for the Wage Substantially All Rule (Reg. § 1.41-2(d))
| Activity Classification | Inclusion in Numerator (Qualified Services) | Inclusion in Denominator (Total Services) | QRE Treatment (If SAR Met ≥80% ) |
| Hands-on Qualified Research (Four-Part Test) | Yes | Yes | 100% of Wages |
| Direct Support/Supervision (Sec. 174 Expenses, per Little Sandy Coal) | Yes | Yes | 100% of Wages |
| Non-Qualified Service (e.g., Marketing, Routine Production) | No | Yes | 100% excluded (If SAR not met: Pro rata inclusion) |
| Non-Service Time (e.g., Sick Leave, PTO) | No | No | N/A (Excluded from calculation base) |
B. Substantially All Rule for Business Components (Process of Experimentation)
The second, more complex, application of the SAR applies at the project level, governing the fundamental qualification of a “business component,” which includes any product, software feature, process, technique, or invention being developed or improved.2 Qualified research, as defined by IRC Section 41(d)(1), requires that substantially all of the activities of the research for that component must constitute elements of a Process of Experimentation (PoE) related to a qualified purpose—specifically, a new or improved function, performance, reliability, or quality.4
The 80% threshold applies rigorously here: the requirement is satisfied only if $80\%$ or more of a taxpayer’s research activities for that component constitute elements of a PoE.3 Crucially, the regulations mandate that this measurement be based on a cost basis or other consistently applied reasonable basis.3 Activities related merely to style, taste, cosmetic, or seasonal design factors are explicitly excluded from the definition of a qualified purpose and thus cannot contribute to the $80\%$ threshold.7
If the $80\%$ PoE threshold is met on a cost basis, the remaining 20% or less of activities may still be included as qualified research, provided they qualify as specified research or experimental expenditures under Section 174 and are not otherwise excluded from the definition of qualified research under Section 41(d)(4).3 The difficulty in defending this cost basis is considerable. Unlike the wage rule, which relies on hours, the cost basis introduces complexities associated with allocating material costs, third-party contract research costs, and indirect labor costs meticulously across PoE versus non-PoE activities for each business component. The lack of detailed regulatory guidance defining the precise measurement of the “cost basis” exposes taxpayers to auditors who may challenge the allocation methodology, arguing that high non-PoE costs (such as routine prototype fabrication) breach the 80% threshold.
II. Strategic Mitigation and Judicial Precedent
The increasing scrutiny applied by the IRS regarding the SAR for business components makes strategic mitigation essential, focusing on the definition of the component and the use of the Shrink-Back Rule.
A. Strategic Mitigation: The Shrink-Back Rule
The Shrink-Back Rule is the primary defensive mechanism available when a business component, as initially defined, fails the 80% SAR (i.e., less than 80% of activities/costs are PoE).2 This rule permits the taxpayer to reduce or “shrink back” the scope of the business component until the remaining, narrower scope successfully meets the Substantially All requirement.2
Proper application of the Shrink-Back Rule is essential for preventing full project disallowance.8 For instance, if a company develops a complex software product, and the overall activities only show a 65% PoE ratio (failing the SAR), the company must apply the Shrink-Back Rule to isolate the innovative, experimental modules (e.g., a new predictive algorithm) from the routine, non-experimental aspects (e.g., standard user interface development). The final claim is then limited to the narrowly defined, qualifying component, ensuring that 80% or more of its activities constitute a process of experimentation.2 This application should be performed proactively during the credit calculation phase to define a defensible claim, rather than reactively during an audit, as indicated by case law that penalizes failure to properly apply the rule.6
B. Judicial Review and Heightened IRS Scrutiny
Recent case law illustrates the critical importance of documentation and the IRS’s intensified focus on the business component SAR.
The decision in Little Sandy Coal v. Commissioner 6 confirmed the IRS’s ability to deny credits due to deficient documentation. Although the appellate court provided technical clarity on including support costs in the wage SAR calculation, it ultimately upheld the rejection of the taxpayer’s claim primarily because the firm failed to provide contemporaneous documentation necessary to substantiate which employee activities qualified as research and to prove the SAR was met.6 This demonstrates that technical eligibility is secondary to the procedural proof required by the $80\%$ threshold.
Furthermore, cases like Intermountain Electronics v. Commissioner 3 are symptomatic of the IRS’s intensified focus on strictly applying the SAR at the business component level.3 The IRS is increasingly scrutinizing the taxpayer’s definition of the component and rejecting overly broad definitions that dilute the Process of Experimentation activities with general development or production costs.3 This litigation trend indicates that aggressive component definitions—where the PoE activities barely meet the threshold—are highly exposed to challenge, emphasizing the necessity of adopting conservative, narrow component definitions and utilizing the Shrink-Back Rule liberally during calculation.
III. Practical Application and Strategic Next Steps
The Substantially All Rule acts as a gateway for nearly all R&D credit claims, requiring both careful application to personnel costs and rigorous evaluation of project scope.
Example: Dual Application of the Substantially All Rule
Consider a technology company developing a new proprietary sensor system, designated as the business component.
- Wage SAR Application: A lead materials scientist spends 84% of their recorded time analyzing, formulating, and testing alternative chemical compounds to meet new performance specifications (activities constituting the four-part test, including the Process of Experimentation). The remaining 16% is spent on administrative reporting and non-R&D team meetings. Since the documented time is $84\%$—which is “substantially all”—the company is eligible to claim 100% of the materials scientist’s salary as a QRE, under the wage SAR.2
- Business Component SAR Application: If the overall project activities and associated costs for the sensor system show that only 75% of the total costs relate to the Process of Experimentation (e.g., due to high costs associated with routine integration testing that does not involve evaluating alternatives), the business component SAR is failed (as 75% is less than 80%). To salvage the credit, the company must use the Shrink-Back Rule. The company narrows the business component scope to focus only on the initial chemical compound formulation and testing phase, where 95% of the costs involved the PoE. By shrinking back, the company isolates the defensible, qualifying research component, thereby meeting the SAR and validating the claim for that specific portion of the project.
Next Steps to Further Clarify and Explain the Substantially All Rule
To enhance compliance and reduce the high level of audit contention associated with the Substantially All Rule, taxpayers and tax professionals should focus on implementing the following strategic steps:
- Implement Integrated Time-Tracking and Cost Accounting Systems: Given the IRS’s focus on the $80\%$ PoE threshold, organizations must move beyond simple tracking of total R&D hours. It is imperative to systematically segment expenditures based on the specific application of the SAR. Time-tracking systems should categorize activities not only by qualified R&D status (for the wage SAR) but also specifically as elements of the Process of Experimentation (PoE) versus general support or non-experimental activities (for the business component SAR).2 This integration ensures that costs are mapped directly to experimental milestones, fulfilling the regulatory requirement for measurement on a “cost basis” 3 and significantly minimizing the gap between documented time and defensible costs.
- Conduct Proactive, Defensive Shrink-Back Analysis: Taxpayers must adopt a mandatory pre-filing protocol to evaluate every defined business component against the 80% PoE threshold. Where initial component definitions fail or are highly exposed to failure, the Shrink-Back Rule must be immediately and deliberately applied to narrowly define the claimable component scope.2 This strategic compliance step turns a potential full disallowance (for a failed broad component) into a highly defensible, targeted claim, mitigating the audit risks demonstrated in recent case law.3
- Advocate for Formal Regulatory Clarification on Cost Basis Measurement: The ambiguity surrounding the precise definition and measurement of the “cost basis” used for the business component SAR (Reg. § 1.41-4(a)(6)) remains a primary source of audit contention.3 Tax professionals and industry bodies should advocate for comprehensive guidance, such as revised Treasury Regulations or specific Revenue Rulings, clarifying which expenditure types (e.g., specialized materials, contract research, internal labor) must be included in the cost basis and how they should be allocated consistently to specific PoE activities. Clear guidance in this area is essential to reduce administrative complexity and litigation risk.
Codify Little Sandy Coal into Internal Compliance Manuals: Internal compliance and time-tracking protocols must formally incorporate the judicial clarification from Little Sandy Coal 6, ensuring that direct support and direct supervision costs (when properly documented as Section 174 expenses) are counted in both the numerator and the denominator of the wage SAR calculation.6 Utilizing this legally defensible mechanism allows firms to maximize QREs for supervisory personnel while maintaining strict adherence to current judicial precedent.
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What is the R&D Tax Credit?
The Research & Experimentation Tax Credit (or R&D Tax Credit), is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States. The credits are a tax incentive for performing qualified research in the United States, resulting in a credit to a tax return. For the first three years of R&D claims, 6% of the total qualified research expenses (QRE) form the gross credit. In the 4th year of claims and beyond, a base amount is calculated, and an adjusted expense line is multiplied times 14%. Click here to learn more.
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