What is the Federal R&D Tax Credit Glossary?
This glossary provides authoritative definitions for the technical terminology governing the United States Federal Research and Experimentation Tax Credit (Section 41) and Research and Experimental Expenditures (Section 174). Designed for finance professionals and CPAs, this resource decodes complex IRS definitions—such as Qualified Research Expenses (QREs), the Four-Part Test, and Internal Use Software—to assist in the accurate identification and substantiation of R&D tax claims. Each term is linked to a detailed resource page for in-depth compliance guidance.
Federal R&D Tax Credit Glossary
Explore our comprehensive list of definitions related to R&D tax incentives.
| Glossary Term | Definition |
|---|---|
| Section 41 | The section of the Internal Revenue Code (IRC) that establishes the Credit for Increasing Research Activities, commonly known as the R&D Tax Credit. It provides a dollar-for-dollar reduction in federal income tax liability for companies engaging in qualified research. |
| Section 174 | The IRC section that governs the tax treatment of Research and Experimental (R&E) expenditures. Post-TCJA, it requires taxpayers to capitalize and amortize these costs over 5 years (domestic) or 15 years (foreign) rather than expensing them immediately. |
| Qualified Research Expenses (QREs) | Eligible costs incurred during the research process that can be used to calculate the R&D tax credit. These strictly include in-house wages, supplies used in research, and a specific percentage of third-party contract research expenses. |
| Four-Part Test | The statutory framework used to determine if a project qualifies for the R&D credit. To qualify, activities must satisfy four specific criteria: Permitted Purpose, Technological in Nature, Elimination of Uncertainty, and Process of Experimentation. |
| Permitted Purpose | One of the Four-Part Tests requiring that the research relates to a new or improved business component. The activity must be intended to improve functionality, performance, reliability, or quality. |
| Technological in Nature | A requirement that the research must fundamentally rely on principles of the hard sciences, such as engineering, physics, biology, or computer science. Activities based on soft sciences like economics or psychology are excluded. |
| Elimination of Uncertainty | A condition met if the information available at the outset of the project does not establish the capability or method for developing the business component, or its appropriate design. The research must aim to discover this missing information. |
| Process of Experimentation | A systematic process designed to evaluate one or more alternatives to achieve a result where the capability, method, or design is uncertain at the start. This typically involves modeling, simulation, or systematic trial and error. |
| Business Component | Any product, process, computer software, technique, formula, or invention to be held for sale, lease, or license, or used by the taxpayer in a trade or business. The R&D credit eligibility is evaluated at the business component level. |
| Shrink-Back Rule | A rule that allows the R&D tests to be applied to a sub-component or subset of a project if the larger business component fails to qualify. This preserves the credit for specific innovative elements within a larger non-qualifying system. |
| Wages | Compensation paid to employees for the performance of qualified services, including direct research, supervision, or support. It includes salaries and bonuses but generally excludes fringe benefits and stock options. |
| Supplies | Tangible property used in the conduct of qualified research. This excludes land, improvements to land, and depreciable property, but includes items like raw materials used for prototypes and testing. |
| Computer Rental | Amounts paid for the lease or rental of computers, including cloud computing costs, used in the conduct of qualified research. These costs must be directly allocable to the R&D activity. |
| Contract Research Expenses | Payments made to a third party to perform qualified research on behalf of the taxpayer. Generally, only 65% of these payments can be claimed as QREs. |
| Cloud Computing Costs | Expenses for hosting and computing power (e.g., AWS, Azure) necessary for development and testing environments. To be eligible, these costs must be essentially equivalent to renting a computer for research purposes. |
| Regular Research Credit (RRC) | A calculation method that determines the credit as 20% of the excess of current year QREs over a base amount. It requires historical gross receipts and expense data, which can be complex to calculate. |
| Alternative Simplified Credit (ASC) | A calculation method that equals 14% of the excess of current QREs over 50% of the average QREs for the three preceding years. It is often used by companies that do not have the historical records required for the RRC. |
| Base Amount | A benchmark figure used in the Regular Research Credit calculation, derived from the fixed-base percentage and average annual gross receipts. The taxpayer must exceed this amount to claim a credit under the RRC method. |
| Fixed-Base Percentage | The ratio of aggregate QREs to aggregate gross receipts for a specific historical period (often 1984-1988 or the first 5 years of the company). It caps at 16% and is a key factor in calculating the Base Amount. |
| Average Annual Gross Receipts | The average of the gross receipts for the four tax years preceding the credit year. This figure is essential for determining the Base Amount in the Regular Research Credit calculation. |
| Start-Up Provision | Specific rules for determining the fixed-base percentage for companies that began after the 1980s benchmark period. It assigns a statutory 3% fixed-base percentage for the first five tax years with QREs and gross receipts. |
| Payroll Tax Election | A provision allowing Qualified Small Businesses (QSBs) to apply up to $250,000 (increased to $500,000 starting 2023) of their R&D credit against the employer portion of payroll taxes. This benefits startups with no income tax liability. |
| Qualified Small Business (QSB) | A corporation or partnership with less than $5 million in gross receipts for the credit year and no gross receipts prior to the 5-year period ending with the credit year. Only QSBs are eligible for the payroll tax offset. |
| PATH Act | The Protecting Americans from Tax Hikes Act of 2015, which made the R&D credit permanent. It also introduced the payroll tax offset for small businesses and allowed eligible small businesses to claim the credit against AMT. |
| Tax Cuts and Jobs Act (TCJA) | The 2017 tax reform legislation that reduced corporate tax rates and introduced changes to Section 174. It mandates the capitalization and amortization of R&E expenditures for tax years beginning after December 31, 2021. |
| Amortization of R&E | The process of deducting research and experimental expenditures over a specific period (5 or 15 years) rather than expensing them in the year incurred. This is now mandatory under Section 174 post-TCJA. |
| Capitalization | The accounting treatment where costs are recorded as an asset on the balance sheet rather than an expense. Under new Section 174 rules, R&D costs must be capitalized and then amortized. |
| Mid-Year Convention | A convention used in amortization where assets (or R&E expenditures) are treated as placed in service at the midpoint of the year. This affects the calculation of the amortization deduction in the first and last years. |
| Section 280C Election | An election to claim a reduced R&D credit to avoid the requirement of reducing the Section 174 deduction by the amount of the credit. This simplifies tax preparation and avoids book-tax adjustments. |
| Reduced Credit | The credit amount resulting from a Section 280C election, calculated by reducing the full credit by the corporate tax rate (currently 21%). This prevents double-dipping of the benefit. |
| Controlled Group | A group of corporations related through stock ownership that are treated as a single taxpayer for R&D credit purposes. This requires the aggregation of QREs and gross receipts to calculate the credit at the group level. |
| Common Control | Relationship between trades or businesses (partnerships, sole proprietorships, etc.) where the same interests own a controlling stake. Entities under common control must aggregate their figures for the credit calculation. |
| Aggregation Rules | Regulations requiring that all members of a controlled group or businesses under common control are treated as a single taxpayer. This prevents the manipulation of the credit by shifting expenses between related entities. |
| Consistency Rule | The requirement that QREs and gross receipts in the base period must be determined on a basis consistent with the current credit year. It ensures the comparison between current and historical R&D activity is accurate. |
| Internal Use Software (IUS) | Software developed by the taxpayer primarily for internal administrative functions (e.g., HR, payroll) rather than for sale or interaction with third parties. IUS must meet a higher standard, the “High Threshold of Innovation,” to qualify. |
| High Threshold of Innovation | An additional test for Internal Use Software. It requires the software to be innovative, involve significant economic risk, and not be commercially available for use without modification. |
| Dual Function Software | Software developed for both internal use and for interaction with third parties. A subset of the software allowing third-party interaction may be exempt from the stricter Internal Use Software rules. |
| Third-Party Subset | The portion of dual-function software specifically designed to enable third parties to initiate functions or review data. This subset is not treated as Internal Use Software. |
| Commercial Availability | A factor in the High Threshold of Innovation test. If software is commercially available to the taxpayer and can be used without substantial modification, developing a custom solution may not qualify. |
| Significant Economic Risk | A requirement for Internal Use Software, stating that the taxpayer must commit substantial resources to the development and there must be substantial uncertainty that the resources will be recovered within a reasonable time. |
| Funded Research | Research performed where the taxpayer does not retain rights to the results or where payment is contingent on success. Funded research is excluded from the R&D tax credit. |
| Financial Risk | A condition for claiming the credit on contract research. The taxpayer must bear the expense even if the research fails; if payment is guaranteed regardless of the outcome, the research is considered funded and ineligible. |
| Substantial Rights | The requirement that the taxpayer must retain substantial rights to the research results. While exclusive rights are not required, the taxpayer must have the right to use the results in their business without paying further royalties. |
| Fixed-Price Contract | A contract where the vendor is paid a set amount regardless of the hours worked or outcome. In these arrangements, the vendor typically bears the financial risk, making them the party eligible to claim the R&D credit. |
| Cost-Plus Contract | A contract where the vendor is reimbursed for costs plus a profit margin. The hiring party usually bears the financial risk in these agreements and is often the one eligible to claim the R&D credit. |
| Time and Materials Contract | A contract structure where payment is based on time spent and materials used. Similar to cost-plus, the financial risk often lies with the hiring party, potentially allowing them to claim the credit. |
| Capped Contract | A time and materials contract with a maximum price ceiling. These can be complex; if the cap is reached, the risk shifts to the contractor, potentially altering who can claim the credit for the overage. |
| Research After Commercial Production | Activities conducted after a business component is ready for commercial use. These are generally excluded from the credit unless they involve significant improvements meeting the Four-Part Test. |
| Adaptation | The modification of an existing business component to a particular customer’s requirement or need. Simple adaptation that does not involve resolving uncertainty is excluded from the R&D credit. |
| Duplication | Reproducing an existing business component (reverse engineering) from a physical examination, plans, or specifications. This is strictly excluded from qualified research. |
| Reverse Engineering | The process of deconstructing a competitor’s product to understand how it works. Activities classified as reverse engineering to duplicate a product are excluded from the R&D tax credit. |
| Routine Data Collection | Standard gathering of data for quality control, market research, or efficiency surveys. These activities do not qualify as research and experimentation under Section 41. |
| Quality Control Testing | Testing to ensure a product meets standard specifications during production. This is distinct from testing during the development phase and is excluded from the R&D credit. |
| Efficiency Surveys | Studies aimed at improving management organization or efficiency. These are considered management functions, not technological research, and are excluded from the credit. |
| Management Functions | Activities related to the oversight and administration of a business, such as financial analysis or personnel management. These are excluded from qualified research activities. |
| Social Sciences Exclusion | The statutory exclusion of research in the social sciences, arts, or humanities (e.g., economics, psychology, sociology) from the R&D tax credit. Only research in the hard sciences qualifies. |
| Foreign Research | Research conducted outside the United States, Puerto Rico, or U.S. possessions. Such activities do not qualify for the U.S. federal R&D tax credit, though they may be amortized under Section 174. |
| Humanities Exclusion | Similar to the social sciences exclusion, this prevents research in fields like history, literature, or arts from qualifying for the credit, as they are not technological in nature. |
| Audit Defense | The process of defending an R&D tax credit claim during an IRS examination. It involves presenting documentation, legal arguments, and subject matter expertise to substantiate the claimed credits. |
| Contemporaneous Documentation | Records created at the time the research was performed. While not strictly required by statute, it is the gold standard for substantiating a claim and is highly preferred by the IRS over retroactive estimations. |
| Nexus | The required connection between the qualified research expenses (wages, supplies, contractors) and the qualified research activities. Taxpayers must demonstrate how specific costs relate to specific projects. |
| Project Accounting | A system of tracking costs by specific projects or jobs. Having project accounting in place greatly simplifies the process of identifying and substantiating R&D costs for the tax credit. |
| Credible Testimony | Oral or written statements from employees or experts that can be used to substantiate R&D activities, especially when documentation is imperfect. However, it is rarely sufficient on its own without some corroborating evidence. |
| General Business Credit | A basket of various tax credits, including the R&D credit, that can be used to offset income tax. There are limitations on how much of the General Business Credit can be used in a single tax year. |
| Statistical Sampling | An IRS-approved method for estimating R&D expenses for large taxpayers. It allows the review of a statistically valid sample of projects to project the QREs for the entire population. |
| ASC 730 Directive | An IRS safe harbor allowing Large Business and International (LB&I) taxpayers to use their GAAP financial statement R&D (ASC 730) as a starting point for their tax return R&D credit, simplifying the audit process. |
| Form 6765 | The IRS tax form titled “Credit for Increasing Research Activities.” This is the form filed with the corporate tax return to claim the federal R&D tax credit. |
| Form 8974 | The form titled “Qualified Small Business Payroll Tax Credit for Increasing Research Activities.” It is filed to apply the R&D credit against the employer’s portion of social security tax. |
| Form 3800 | The IRS form for the “General Business Credit.” The total credit calculated on Form 6765 flows into this form, which aggregates various business credits and applies limitation rules. |
| Amended Return | A tax return filed to correct errors or claim missed credits from a previous year. Taxpayers can file amended returns (typically Form 1120-X) to claim R&D credits for open tax years (usually the last 3 years). |
| Audit Techniques Guide (ATG) | Manuals published by the IRS to guide examiners on specific issues, including the R&D tax credit. These guides are valuable resources for taxpayers to understand what auditors look for. |
| Information Document Request (IDR) | A formal request from an IRS agent during an audit asking for specific documents or information. Responding effectively to IDRs is critical during an R&D credit examination. |
| Notice of Claim Disallowance | A formal letter from the IRS denying a claim for a refund or credit. This triggers a specific window during which the taxpayer can appeal or file suit in court. |
| Pilot Model | A representation or model of a business component produced to evaluate and resolve uncertainty during development. The costs of producing pilot models are often eligible QREs. |
| Prototype | An early sample or model of a product built to test a concept or process. Prototype costs are generally deductible as QREs provided the primary purpose is to eliminate technical uncertainty. |
| First-in-Class | Refers to a product or solution that is the first of its kind in the market or industry. While not a strict requirement (innovation can be incremental), first-in-class projects strongly support the “technological in nature” test. |
| Direct Supervision | Qualified services performed by an individual who directly oversees researchers. The wages of first-line supervisors (but not high-level managers) can be claimed as QREs. |
| Direct Support | Qualified services performed by individuals who support the research activities, such as a machinist cleaning equipment used in R&D or a clerk typing research reports. These wages are eligible QREs. |
| Qualified Services | Services comprising qualified research, direct supervision of qualified research, or direct support of qualified research. Only wages paid for these specific services are eligible for the credit. |
| Substantially All Rule | A rule stating that if at least 80% of an employee’s time or a project’s activities constitute qualified research, then 100% of the relevant wages or costs may be included in the credit calculation. |
| De Minimis Rule | Specifically for Internal Use Software, this rule allows software to be treated as non-IUS if the internal use functions are trivial compared to the interaction with third parties. |
| Patent Safe Harbor | A provision stating that the issuance of a U.S. patent is conclusive evidence that a business component meets the “Discovery of Information” and “Business Component” tests, though other tests must still be met. |
| Incident to Development | Costs that are supportive of the research process, such as utilities, rent, or overhead. While allocable under Section 174, many of these indirect costs are NOT eligible for the Section 41 credit. |
| Specified Research or Experimental Expenditures (SRE) | The term used in amended Section 174 to describe costs that must be capitalized. This includes all direct R&D costs and a reasonable allocation of indirect costs (overhead, depreciation, etc.). |
| Research and Experimental (R&E) Expenditures | A broad category of costs incurred in connection with the taxpayer’s trade or business representing research and development costs in the experimental or laboratory sense. |
| General and Administrative (G&A) Functions | Routine business activities such as payroll, human resources, and financial accounting. Software developed for these functions is classified as Internal Use Software and faces stricter eligibility requirements. |
| Interactive Software | Software that enables third parties to initiate functions or review data. This functionality helps exempt software from the strict “Internal Use Software” limitations. |
| Hardware-Software Integration | The process of combining software with hardware components. Issues arising from this integration often create the technical uncertainty required to qualify for the R&D credit. |
| Specially Designed Software | Software that is part of a hardware product and is not sold separately. This is generally not treated as Internal Use Software, making it easier to qualify for the credit. |
| ERP Implementation | The process of installing Enterprise Resource Planning systems (like SAP or Oracle). While configuration is often routine, custom coding or developing “bridging” software may qualify as R&D if technical uncertainty exists. |
| Clinical Trials | Research studies performed on people to evaluate a medical, surgical, or behavioral intervention. Costs associated with clinical trials (Phases I-IV) often constitute a significant portion of QREs for pharmaceutical companies. |
| Patent Perfection Costs | Legal and filing fees associated with securing a patent. While these costs are amortizable under Section 174, they are generally NOT eligible Qualified Research Expenses for the Section 41 credit. |
| Extraordinary Utilities | Utility costs (electricity, water) that are significantly higher due to the demands of the research activity. In rare cases, these can be claimed as QREs if they are considered “supplies.” |
| Carryforward | A provision allowing taxpayers to save unused R&D credits for future years. If the credit exceeds the tax liability limit, it can generally be carried forward for up to 20 years. |
| Carryback | The ability to apply current year unused credits to previous tax years. General business credits can typically be carried back one year to recover taxes previously paid. |
| Section 41(g) | A special rule for pass-through entities and individuals, limiting the credit they can use to the amount of tax attributable to the specific business that generated the credit. |
| Pass-Through Entity | Business structures like S-Corps, Partnerships, and LLCs where income and credits flow through to the owners’ personal tax returns. R&D credits are allocated to shareholders/partners based on ownership. |
| Qualified Organization | Certain educational institutions and scientific research organizations. Payments to these organizations for basic research can qualify for a credit under special “Basic Research” rules. |
| Basic Research Payments | Payments made in cash to a qualified organization for basic research (research with no specific commercial objective). These payments may qualify for a separate 20% credit calculation. |
| Energy Research Consortium | A tax-exempt organization established to conduct energy research. Payments to such consortiums are treated favorably, with 100% of the payment often eligible as a QRE. |
