Understanding the IRS Four-Part Test for R&D Tax Credits


October 5, 2022


The Research and Development (R&D) Tax Credit was originally set up in the 1980s to encourage innovation and competition for U.S. businesses.  Now a permanent fixture, it’s important to understand if your startup or small business qualifies so you can benefit from the credit.  In 2021, more companies are using custom machinery, software, and robust operations to advance their products or processes.  This increase in innovation allows for more businesses than ever before to qualify for the tax benefit.   

Applying for the credit may be your ticket to reducing federal or payroll taxes by a percentage of costs you incur from the time, material, and wages spent on qualifying activities. 

The IRS has established a four-part test to help determine and if your company’s activities could potentially qualify:

1. Permitted purposes: Your company’s activities should relate to a new or improved business component’s function, composition, performance, reliability, or quality.  

  • In much easier terms. This doesn’t necessarily mean you have to discover something that’s a breakthrough for your entire industry, but what may be innovative or new to your company’s products or processes. 

2. Technological in nature: Performed activities must fundamentally rely on principles of physical or biological science, computer science, or engineering.  

  • A food example.  If you are in food production, simply changing a recipe or adding more hot sauce may not qualify, but a method based on hard science to improve your product’s flavor or freshness will qualify. 

3. Elimination of uncertainty: Your company’s activities are intended to uncover information to eliminate uncertainty concerning the capability, method, or design for developing or improving a product or process.

  • Good news! If you took on a project that did not yet succeed (we prefer that term over “failed”), not all is lost.  What counts in the eyes of the IRS is the validity of the project’s processes, not the outcome.  So all that effort you spent last year on researching and developing space pants could still save you money. 

4. Process of experimentation: The qualifying activities of the company must constitute the process of experimentation, which may include modeling, testing, simulation, or a systematic trial and error methodology, confirmation of hypotheses, or redefining/discarding of hypotheses.

If you passed this four-part test - or even if you didn’t - it’s time to pursue the possibilities of your credit. Use our free evaluation to quickly assess your potential credit amount. If you have more questions, you can always contact us