Most SaaS companies do qualifying research every sprint: building new features, solving scaling problems, designing algorithms and integrations whose outcome was uncertain when the work started. The federal credit for increasing research activities under IRC §41 rewards that work, and for early-stage companies it can be turned into cash through payroll taxes.
What qualifies: the four-part test
Activities qualify only if they meet all four tests for each business component (a product, feature, process or piece of software):
- Section 174 test. The costs are research or experimental expenditures in the experimental or laboratory sense.
- Technological information test. The research relies on principles of computer science, engineering or the physical sciences.
- Business component test. It is meant to create a new or improved function, performance, reliability or quality of a business component.
- Process of experimentation test. Substantially all of the activity involves evaluating alternatives to resolve technical uncertainty.
Routine bug fixes, cosmetic UI changes, data entry and work after commercial release generally do not qualify. Internal-use software faces an additional, higher threshold.
Qualified research expenses (QREs)
| Category | What counts |
|---|---|
| Wages | Taxable wages of employees who perform, directly supervise or directly support qualified research |
| Supplies | Supplies used in research; for software, certain cloud computing costs for development and testing environments |
| Contract research | Generally 65% of amounts paid to US contractors performing qualified research on your behalf |
Time tracking, sprint records and design documents are the evidence. Building the documentation as work happens is far easier than reconstructing it at filing time.
Two ways to compute the credit
- Regular credit: 20% of QREs above a historical base amount.
- Alternative simplified credit (ASC): 14% of QREs above 50% of the average QREs of the prior three years, with a reduced rate when there are no QREs in any of those years.
Most startups use the ASC because the regular credit's base calculation requires historical gross receipts data that young companies lack.
The payroll tax election for startups
A qualified small business (generally gross receipts under $5 million for the year and no gross receipts more than five years back) can elect to apply up to $500,000 of the credit per year against payroll taxes, for tax years beginning after December 31, 2022. The election is made on Form 6765 with a timely filed original return; the credit is then claimed quarterly on Form 8974 with the employment tax return, starting with the first quarter after the income tax return is filed.
How it interacts with Section 174
The credit and the deduction for research costs are related but separate. Research costs must also be handled under the current Section 174 and 174A rules, which changed for tax years beginning after 2024. See our guide to Section 174 for the timing rules.
What we prepare
We identify qualifying projects with your engineering leads, quantify QREs from payroll and vendor records, prepare Form 6765 including the business-component detail the IRS now requests, and coordinate the payroll tax election with your payroll provider.
Sources
- IRS, Instructions for Form 6765, Credit for Increasing Research Activities
- IRS, Instructions for Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities
- IRS, Research credit against payroll tax for small businesses
Questions founders ask
Can a pre-profit startup benefit from the R&D credit?
Yes. A qualified small business can elect to apply up to $500,000 of the credit against the employer share of payroll taxes each year, so the credit produces cash before the company has income tax to offset.
Can the payroll tax election be made on an amended return?
No. The IRS instructions require the election on Form 6765 filed with a timely original return, including extensions.
