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Many businesses invest heavily in innovation, developing new technologies, improving systems, and solving technical problems. However, when it comes time to claim the Research and Development (R&D) Tax Credit, they often come up short because they fail to demonstrate a proper process of experimentation, which is a core requirement under Internal Revenue Code Section 41.
Understanding and documenting this process is not just a formality, as it is the difference between a claim that holds up under IRS scrutiny and one that gets disallowed. Section 41 of the tax code stipulates that eligible R&D activities must involve a process of experimentation, a systematic method aimed at eliminating technical uncertainty.
This means your team must have a methodical plan involving a series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis. Too often, companies misunderstand this requirement. They describe projects in broad terms like “we built a new system” or “we improved a product,” without detailing how this was accomplished, but the IRS wants evidence of how a team tested hypotheses, evaluated results, and adjusted their approach.
Without this level of documentation, even the most technically advanced work can potentially be ruled ineligible.
Define Hypotheses and Technical Uncertainties
Every valid R&D project begins with a challenge, something researchers did not know how to solve at the outset. To qualify for the credit, they must identify these technical uncertainties and the hypotheses the team developed to resolve them.
This could include questions like:
- Can we achieve this functionality within performance specs?
- Which material composition will meet our durability needs?
- Will this algorithm improve data accuracy under real-world conditions?
Clearly stating these technical unknowns and the assumptions or ideas tested to solve them is the foundation of an experimentation claim.
Detailed Iterative Testing and Evaluation
R&D is not a straight line. It is a loop of constant testing, refining, and learning. To satisfy the IRS, documentation should reflect that.
For every hypothesis, include records of:
- Experiments conducted
- Test conditions and variables
- Results of both successes and failures
- Adjustments made based on findings
This trial-and-error cycle is at the heart of what the IRS considers “qualified research.” Even failed attempts are valuable, as long as they show the team was actively trying to overcome technical challenges. Good sources of documentation include lab notes, test reports, prototype revisions, internal emails discussing changes, and project management logs tracking iterations.
Verify a Systemic Approach
It is not enough to say researchers experimented. The team needs to show that they followed a methodical approach grounded in the hard sciences, engineering or computer science principles. The IRS looks for structured processes such as:
- Modeling and simulation
- Prototyping and bench testing
- Data collection and analysis
- Software development iteration
These activities demonstrate that the team applied technical disciplines in a repeatable, consistent way, rather than relying on guesswork or ad hoc changes. Make sure documentation includes timelines, development stages, team roles, and evidence of cross-functional collaboration to reinforce the organized nature of the experimentation process.
Conclusion
The R&D Tax Credit is a powerful tool, but only if claims are properly substantiated. The process of experimentation is not optional, as it is a defining element of qualified research under Section 41. By clearly identifying hypotheses, detailing how they were tested, and demonstrating a structured engineering methodology, businesses dramatically improve the odds of a successful claim and insulate themselves from costly audit risk.
Those unsure whether their current documentation meets these expectations are encouraged to contact a KBKG expert today to learn more about how to qualify.