Determining Qualified Research Expenses (QREs) on a Business-Component Basis Under IRC Section 41
QREs Must Be Determined on a Business-Component Basis
Under IRC Section 41(d)(2), businesses seeking to claim the Research & Development (R&D) Tax Credit must determine their Qualified Research Expenses (QREs) on a business component-by-business component basis. This requirement is reiterated in Treas. Reg. §1.41-4(b)(1), which mandates that each research activity must be tied to a specific business component in order to assess whether it meets the statutory four-part test for qualified research.
The IRS argues this granular approach ensures that taxpayers systematically evaluate their research expenditures based on discrete products, processes, techniques, formulas, inventions, or software and further argues that quantifying qualifying activities can only be determined in the context of each business component. The IRS is also ramping up disclosure requirements on business components starting this year.
Starting in 2024, All taxpayers must now identify the number of business components on their tax return filing
Starting with the 2024 tax year, taxpayers must now identify the specific number of qualifying business components used in determining the company’s QREs. This is the first time in the US R&D tax credit’s nearly 45-year history that this has been required to be disclosed specifically on the tax return.
Practical implication: While this is not generally advised, instead of performing a substantive study some taxpayers will instead do a high-level R&D credit calculation estimate to include on the tax return position without not performing any analysis on a business component-by-business component basis. Now, taxpayers have to identify the number of business components on the tax return. And starting in the 2025 tax year many taxpayers will be required to provide detailed qualitative information about each qualifying business component on the actual tax return.
Read more about the revised federal R&D tax credit form and requirements (here).
Defining a Business Component
A business component is defined under IRC Section 41(d)(2)(B) as a product, process, computer software, technique, formula, or invention that is either:
Held for sale, lease, or license, OR
Used in the taxpayer’s trade or business.
Each business component must be evaluated independently to determine whether the research activities associated with its development meet the four-part test for qualified research:
Permitted Purpose Test – The research must aim to develop or improve a business component’s functionality, performance, reliability, or quality.
Technological in Nature Test – The research must rely on principles of physical or biological sciences, engineering, or computer science.
Elimination of Uncertainty Test – The taxpayer must seek to eliminate uncertainty regarding the development or improvement of the business component.
Process of Experimentation Test – The research must involve a process of experimentation to evaluate alternatives.
Examples of Business Components
Aerospace Industry: The design and testing of a new wing structure for increased fuel efficiency.
Pharmaceutical Industry: The formulation of a new drug compound or the development of an improved drug delivery system.
Software Development: The creation of a new software algorithm to enhance cybersecurity.
Manufacturing: The refinement of an injection molding process to reduce material waste.
Each of these examples represents a distinct business component subject to the qualification criteria under Section 41.
The "Shrink-Back" Rule and Its Application
A key consideration in evaluating QREs is the "shrink back" rule, outlined in Treas. Reg. §1.41-4(b)(2). If a taxpayer determines that an entire business component does not meet the four-part test, the regulation requires the taxpayer to “shrink back” the analysis to smaller elements of the business component to determine if any portion qualifies.
Practical Application of the Shrink Back Rule
Example: Development of an Autonomous Vehicle System
A taxpayer is developing a fully autonomous vehicle.
If the entire vehicle does not meet the four-part test due to certain non-technical design elements, the company may shrink back to specific components like the machine learning algorithm for object detection or the sensor fusion system to determine if those qualify.
Example: Software Development
A company creates an enterprise resource planning (ERP) system with multiple integrated modules.
If the system as a whole does not satisfy the four-part test, the company may shrink back to individual modules (e.g., a new AI-driven inventory management feature) to assess eligibility.
Example: Pharmaceutical R&D
A company working on a new drug formulation finds that the entire formulation does not qualify due to certain exclusions under the credit rules.
The company may shrink back to specific research activities related to optimizing a novel drug delivery method to assess qualification.
Conclusion
While the requirement to determine QREs on a business-component basis has existed since the credit was first introduced in 1981, the new tax return disclosure requirements now compel all taxpayers to conduct a more rigorous analysis. At a minimum, taxpayers must identify the number of business components used in their credit calculation, apply the shrink-back rule where applicable, and prepare for expanded qualitative disclosures starting in 2025. Given these changes, taxpayers should carefully document their research activities, expenditures, and decision-making processes at the business-component level to substantiate their claims and maximize their credit potential.
