The R&D Tax Credit Isn't Just for Tech Companies

Key Takeaways

• The R&D tax credit isn't limited to tech companies. Manufacturing, food and beverage, agriculture, engineering, and even professional services firms have qualified.
• The IRS uses a four-part test to determine what counts as qualifying research. It's about the nature of the work, not the industry.
• In an AI-driven world, businesses building internal tools, training custom models, or testing AI-assisted workflows may qualify, even if they don't think of themselves as tech companies.
• The federal credit is worth up to 20% of qualifying expenses above a base amount. Startups with no tax liability can use up to $500,000 of it against payroll taxes instead.
• California has its own R&D credit at 15% of qualifying expenses (24% for very small businesses). It stacks with the federal credit.

Most small business owners have never looked at the R&D tax credit, and most of the ones who have heard of it assume it’s only for software companies or biotech labs.

However, that’s not always the case.

The credit was designed to reward businesses doing technical work to develop or improve a product, process, formula, software, or technique, regardless of industry. What matters is whether you were trying to solve a technical problem through a process of experimentation.

What Qualifies: The Four-Part IRS Test

To claim the R&D credit, each activity you count needs to pass a four-part test.

If your activity passes all four parts, the money you spent on it, including wages, supplies, and certain contractor costs, may count as a qualifying research expense, or QRE.

Industries That Qualify Beyond Software

The list of industries that have successfully claimed the R&D credit is longer than most people realize. Here are some examples:

Manufacturing: Developing new production processes, testing new materials, or designing custom tooling. If your engineers spent time figuring out how to make something work better or cost less to produce, that time may qualify.

Food and beverage: Improving shelf life, developing new recipes, or testing new packaging that extends product quality. The work has to involve technical uncertainty, not just culinary creativity, but many food producers are surprised to learn their product development teams may qualify.

Architecture and engineering: Energy-efficient structural designs, load-bearing innovations, new building systems. If you’re solving a problem that wasn’t solved before and you’re testing your way to the answer, you may be in the ballpark.

Agriculture: New growing techniques, crop yield improvements, precision irrigation systems. Agricultural R&D is an underused area of the credit.

Professional services: If your firm built custom software internally, developed AI-assisted workflows, or created proprietary tools that your staff uses, that development work may qualify, even if your core business has nothing to do with technology.

The AI Angle

This is where it gets relevant for 2024 and beyond. A lot of businesses are actively building things with AI right now, training custom models, integrating AI into internal processes, or developing AI-assisted tools for their teams. Most of them don’t think of that as R&D.

The IRS test doesn’t ask whether you’re a “tech company.” It asks whether you were dealing with technical uncertainty and experimenting your way toward a solution. Building a custom AI tool that automates part of your operations may qualify. Testing whether a model handles your use case well may qualify. Running trials to figure out the right integration may qualify. That kind of experimentation is the type of activity the credit is designed to reward.

That said, not every AI-related project qualifies. Routine implementation, simple prompt use, or off-the-shelf software setup usually won’t be enough on its own.

If your business has spent time and money developing or testing AI-assisted workflows in the last three years, it’s worth having a qualified accountant look at those expenses.

What the Credit Is Worth

The federal R&D credit can be calculated in different ways. Under the traditional method, it is 20% of qualifying research expenses above a base amount. Many businesses use the simplified credit, which is generally 14% of QREs above 50% of the average QREs from the prior three years.

If you’re a startup with no federal tax liability yet, the credit doesn’t disappear. Certain qualified small businesses may be able to apply up to $500,000 per year against their payroll tax obligation instead. This is one of the most underused provisions in the tax code for early-stage businesses.

What This Looks Like: Marco’s Metal Fabrication Shop

Marco runs a metal fabrication business in the Central Valley with 18 employees and about $3.2M in annual revenue. Two years ago, his team spent eight months developing a new heat treatment process for a custom part they were building for an industrial client. The existing methods weren’t producing consistent results at the tolerances the client needed. Marco’s engineers ran dozens of tests, adjusted variables, and eventually landed on a process that worked.

That eight months of engineering labor, along with the materials they used during testing, may qualify as R&D activity. Marco’s accountant calculated $180,000 in QREs for that year. Using the simplified method, that produced a federal R&D credit of about $25,200, assuming the company had enough credit base activity to support that calculation. On top of that, California’s credit may also apply, depending on the company’s state tax position and base calculation.

Marco didn’t think of his shop as a “research” business. But the four-part test doesn’t care what you call yourself. It cares what you did.

A Note on California

California has its own R&D credit, and it generally runs alongside the federal credit. The standard rate is 15% of qualifying research expenses above a base amount, and for certain basic research payments the rate can be 24%.

The California credit is nonrefundable, meaning it can only reduce your state tax liability to zero. It doesn’t produce a refund. But any unused credit generally carries forward, so you’re not losing it if you don’t use it all in one year.

One important note: California does not conform to the federal payroll tax offset for startups. If you’re a startup using the federal credit against payroll taxes, the California credit is separate and works differently. Talk to your accountant about how to use both.

Why This Matters

The R&D tax credit has existed since 1981. For most of that time, it was treated as a large-company benefit, because claiming it used to require expensive documentation and legal work that small businesses couldn’t justify. That’s changed. The simplified calculation method and clearer IRS guidance have made it more accessible.

The businesses most likely to be leaving money on the table are the ones in traditional industries who never thought to ask. A manufacturer who spent a quarter developing a new production method. A food producer who spent months reformulating a product. A professional services firm that built custom software for internal use. None of them think of themselves as doing R&D. Some of them may still qualify.

The other group is newer businesses building with AI. The tools are new, the applications are new, and the technical uncertainty can be real. That’s exactly the kind of activity the credit was designed to evaluate.

If your business has done any of this work in the last three years, the credits are worth calculating. Amended returns are generally allowed for up to three prior years, so even if you missed it before, there may still be time to claim it.

If you think your business might qualify for the R&D credit and you want to know what the numbers actually look like, that’s a conversation worth having with NCO. We work with California small business owners across a range of industries, and we can help you figure out whether your expenses qualify and how much the credit is worth.

Frequently Asked Questions

Can I claim the R&D credit if my business isn’t profitable yet?

Yes. If your business meets the federal requirements for a qualified small business, you may be able to apply up to $500,000 of the R&D credit against your payroll tax obligation. This is designed specifically for early-stage businesses that are doing qualifying work but don’t owe income tax yet. California’s credit works differently and can’t be applied against payroll taxes.

What records do I need to keep?

You’ll need documentation that shows what the activity was, who worked on it, how much time they spent, and what the goal was. Notes, project logs, timesheets, and test documentation made at the time of the work, are stronger than records reconstructed later. The IRS expects you to be able to show what problem you were trying to solve and what you tried.

Does the work have to succeed to qualify?

No. The credit is based on the process of experimentation, not the outcome. If you tested a process, ran trials, or attempted to resolve a technical uncertainty, and it didn’t work, that activity can still qualify. Failed R&D may still be R&D.

Can I claim expenses for contractor work?

Yes, but only part of the contractor cost may count. In general, 65% of amounts paid to outside contractors for qualified research may be included as QREs, assuming the work meets the rules and the contractor arrangement gives the taxpayer the necessary rights and risk profile.

How far back can I go?

You can generally amend prior-year federal returns to claim the R&D credit for up to three years back, subject to the normal statute of limitations. In some cases, California allows a longer period. If your business has been doing qualifying work and hasn’t claimed the credit, it’s worth asking your accountant whether an amended return makes sense.