A lot of founders assume "R&D expense" means anything spent building the product. That assumption gets expensive. The IRS has a specific, four-part definition of what counts as research in the first place, and then a separate, narrower list of which costs tied to that research actually count as qualified research expenses.
Get the categories wrong, and you either leave real money on the table or hand the IRS an easy reason to disallow the claim. Here's exactly what counts, in plain English, with the California-specific rules layered on top.
The IRS Four-Part Test Comes First
Before any expense can qualify, the underlying activity has to pass the IRS four-part test under Internal Revenue Code Section 41(d). All four parts have to be met for every business component being claimed, not just some of them.
- The Section 174 test. The work has to be a legitimate research and development cost in the experimental or laboratory sense, meaning it's aimed at eliminating real uncertainty about how to build or improve something.
- Technological in nature. The uncertainty has to be resolved using principles of engineering, computer science, or the physical or biological sciences. Market research and consumer surveys don't count, no matter how rigorous.
- Business component test. The research must be aimed at developing or improving a specific product, process, software, technique, or formula that the company sells or uses in its own trade or business.
- Process of experimentation. Substantially all of the activity (the IRS applies an 80% standard) has to involve identifying an uncertainty, proposing alternatives, and systematically testing them. Trial and error counts. Guessing and shipping doesn't.
Example: a Riverside SaaS startup spends $180,000 in Year One building a fraud-detection model for its payments product. The engineers don't know upfront which model architecture will hit the accuracy target, so they test three approaches before landing on one. That's a process of experimentation aimed at a business component, resolved through computer science. It passes all four parts.
Compare that to a startup that pays a contractor to rebuild an existing open-source library with minor tweaks for internal use. Do NOT assume that qualifies. The IRS specifically excludes research conducted after a product is already in commercial production, adapting an existing component to one customer's needs, duplicating something that already exists, routine or efficiency testing, market research, and research performed outside the United States. Get the activity test wrong, and the expense categories below never matter.
The Categories of Qualified Research Expenses (QREs)
Once the activity qualifies, the tax code defines exactly which costs tied to it count. Qualified research expenses are the sum of two buckets: in-house research expenses and contract research expenses. Nothing outside these categories can be claimed, no matter how directly it supported the work.
Wages for Qualified Services
Wages count only to the extent an employee spent time engaging in the research, directly supervising it, or directly supporting it. "Directly supporting" covers real work, like a machinist building a test part or a technician compiling research data. It does NOT cover payroll staff processing paychecks, janitors cleaning a lab, or executives who oversee research from two management levels up.
Job titles don't decide this. A person with "Research Engineer" on a business card whose actual week is 80% customer support work has 80% non-qualifying wages, regardless of the title. Track time by activity, not by department.
There's a useful shortcut built into the rule: if an employee spends 80% or more of their time on qualifying work, the "substantially all" standard lets the company count 100% of that person's wages. Drop below that threshold and only the actual qualifying percentage counts.
Supplies Used in the Research
Supplies means non-depreciable tangible property consumed in the research, like raw materials for a prototype. It does NOT include rent, overhead, license fees, travel, or anything depreciable, like a piece of lab equipment used for years. If a founder tries to write off the office lease as an R&D "supply," that's exactly the kind of claim examiners are trained to catch.
The Right to Use Computers
The same in-house research expense category also covers amounts paid to another party for the right to use computers directly in the conduct of qualified research. In practice, that covers cloud compute and hosting spent running experiments, training models, or load-testing a new architecture, not the everyday production hosting bill or general company IT infrastructure. The distinction is use: infrastructure that exists to run the qualifying research itself can count, and infrastructure that just keeps the lights on for the business does not.
Contract Research and Development: Capped at 65%
Pay an outside developer or lab to do qualifying work on the company's behalf, and only 65% of that payment counts, even when 100% of the work qualifies technically. Three conditions have to be met: the agreement was in place before the work started, the contractor performed the research on the company's behalf, and the company bears the cost even if the research fails. If payment is contingent on success, the IRS treats it as a fee for a result rather than for research, and none of it qualifies.
Foreign contractors carry an extra trap. Research performed outside the United States, Puerto Rico, or a U.S. possession is excluded entirely, even when a domestic company is the one being paid to run the work overseas.
Two Different Things: The Credit and the Deduction
Founders regularly confuse Section 41 (the credit) with Section 174 (the deduction), and it's an expensive mix-up. Passing the Section 174 test is necessary for an expense to be eligible for the Section 41 credit, but it's not sufficient on its own. Patent filing costs, for example, generally qualify as a Section 174 expense but fail the Section 41 test entirely and can't be claimed as a QRE.
There's also a significant 2025 change worth knowing. The One Big Beautiful Bill Act, signed into law on July 4, 2025, created a new Section 174A that restores immediate deduction of domestic research and experimental costs for tax years beginning after December 31, 2024. Before this, the 2017 tax law had forced companies to capitalize and amortize those same costs over five years, a cash-flow problem that hit pre-revenue startups the hardest. Foreign research costs still have to be capitalized and amortized over 15 years; only domestic research got the relief, and the IRS issued detailed implementation guidance on it in Revenue Procedure 2025-28.
None of that changes what counts as a QRE for the credit itself. It changes how quickly a company can deduct the underlying cost. Keep the two provisions separate when planning, and don't let a conversation about "R&D expensing" quietly substitute for one about the credit.
California's Rules for Qualified Research Expenses
California conforms to the federal definition of qualified research expenses: wages, supplies, contract research work, and computer costs such as cloud spend the same way at the state level. Where California pulls away from the federal rules matters most for any startup building outside a single office.
The research has to be physically performed within California to count for the state credit. A startup with engineers split between Riverside and a remote team in another state gets the federal credit on all qualifying wages, but only the California-based portion counts toward the state credit. Track location, not just qualifying activity.
The California credit rate is 15% of QREs over the base amount, plus 24% of basic research payments to universities and qualified organizations. Starting with the 2025 tax year, California also offers an Alternative Simplified Credit: 3% of QREs exceeding 50% of the average QREs from the prior three years, or 1.3% of current-year QREs if any of those three years had none.
The biggest gap founders miss: California's credit is nonrefundable and carries forward indefinitely, but there is no state-level equivalent to the federal payroll tax offset described in the next section. A pre-revenue startup with no California tax liability yet still banks the credit for future years; it just can't turn it into cash the way it can federally.
The Federal Payroll Tax Offset for Pre-Revenue Startups
This is the piece that actually puts cash back in a pre-revenue startup's bank account. A Qualified Small Business, meaning gross receipts under $5 million in the credit year and no gross receipts at all in any year more than five years before that year, can apply up to $500,000 of its federal credit against the employer's share of Social Security and Medicare taxes, for up to five years.
The catch: the election has to be made on Form 6765, attached to the company's original, timely filed income tax return. It cannot be added later by amending a prior return. Miss the window on the original filing and that year's payroll offset is gone, even if the underlying research expenses were airtight. Founders who file on time to claim the credit keep this option open; founders who file late, or plan to fix it later on an amended return, don't.
Documentation the IRS Actually Wants
The IRS has specifically flagged a pattern as a common audit trigger: "prepackaged" R&D studies built after the fact that never tie specific dollars to specific business components. Contemporaneous documentation, meaning records built as the work happens, holds up. Reconstructed narratives written months later generally don't.
At minimum, that means time tracking by project for engineers whose wages are being claimed, invoices and contracts for outside research work, and a clear map from each qualifying dollar to the business component it supported. That's exactly why an AI-enabled R&D Study captures every qualifying expense, matching wages, supplies, cloud costs, and contractor payments to the right category before the return is ever filed.
This is not legal or tax advice. Every startup's facts are different, and R&D credit rules involve real complexity. Consult a qualified tax professional for your specific situation.
FAQ
Does software development qualify as an R&D expense for the tax credit? Often, yes, but not automatically. The development has to involve real technical uncertainty resolved through a process of experimentation, not routine feature work or bug fixes on an already-shipped product. Internal-use software carries an additional, stricter test on top of the standard four-part test.
Can I claim cloud computing or AWS costs as a qualified research expense? Cloud and server costs can qualify under the "right to use computers" provision, but only for the portion used directly in the research itself, like running experiments or training a model. The everyday production hosting bill for a live product doesn't count.
Do contractor invoices count 100% toward the R&D credit? No. Contract research expenses are capped at 65% of the amount paid, and only when the agreement was signed before work began, the contractor worked on the company's behalf, and the company bore the financial risk regardless of outcome. Contracts where payment depends on success don't qualify at all.
What's the difference between the R&D tax credit and the R&D expense deduction? The credit, under Section 41, is a dollar-for-dollar reduction in tax owed based on qualified research expenses. The deduction, under Section 174 (now Section 174A for domestic costs), governs when a company can write off research costs against income. They're different provisions, and passing one test doesn't guarantee passing the other.
Can a pre-revenue startup with no tax liability still benefit from the R&D credit? Yes, through the federal payroll tax offset. A Qualified Small Business, generally one with under $5 million in gross receipts and no revenue before the five-tax-year window ending with the claim year, can apply up to $500,000 of credit against payroll taxes instead of income tax.
Does my California R&D credit shrink if my engineers work remotely outside the state? Yes, for the state credit specifically. California requires the research to be physically performed within the state, so wages for engineers working outside California can still count toward the federal credit but won't count toward the California credit.
