Deeptech Hardware R&D Tax Credits: A Practical Manufacturing Guide to Claiming Cash

Hardware R&D Tax Credits: A US Manufacturing Guide

For deeptech and hardware startups, the path to a viable product is paved with expensive prototypes, materials testing, and complex fabrication. This intensive research and development cycle consumes your most valuable resource: cash runway. While you focus on solving difficult engineering problems, a significant source of non-dilutive capital is often overlooked. The US federal R&D tax credit, especially its payroll tax offset provision, is designed for this exact scenario. It is not just for large corporations; it is a powerful tool for early-stage companies providing hardware innovation funding.

For US companies, qualified startups can claim up to $500,000 in cash back per year against the employer's share of Social Security taxes, an amount increased by the Inflation Reduction Act of 2022. This guide provides a practical walkthrough of how to claim R&D tax credits for hardware startups, focusing on what qualifies, what to document, and how to turn your innovation into a cash refund.

First, Does Your Project Even Qualify? The 4 Questions the IRS Asks

Before you start calculating expenses, you must determine if your work is considered 'R&D' in the eyes of the IRS. The government provides a clear framework called the Four-Part Test. Your project activities must meet all four criteria to qualify. This isn't about your company being innovative in general; it is about specific projects meeting these tests.

1. The Permitted Purpose Test: The research must be for the purpose of creating a new or improved business component, which means a product, process, software, technique, formula, or invention. The goal must be to improve its function, performance, reliability, or quality. For example, a drone company developing a new gimbal system to improve image stabilization for high-wind conditions has a permitted purpose. Similarly, a medical device company creating a novel biocompatible coating for an implant also meets this test.
2. The Technological in Nature Test: The work must fundamentally rely on principles of the hard sciences, such as engineering, physics, chemistry, biology, or computer science. For most hardware and deeptech companies, this test is straightforward to meet. If your team is debating material science properties, fluid dynamics, or electrical engineering principles to solve a problem, you are operating within a technological field. The work cannot rely on soft sciences like economics or marketing.
3. The Elimination of Uncertainty Test: This is a crucial hurdle. At the outset of the project, you must have faced uncertainty concerning the capability or the method of developing or improving the product, or the appropriateness of the product's design. If the solution was obvious or already known in your industry, the work does not qualify. This uncertainty must be technical, not commercial. For example, uncertainty about whether customers will buy your product does not count, but uncertainty about whether a new manufacturing process can achieve the required tolerances does.
4. The Process of Experimentation Test: You must demonstrate that you engaged in a systematic process designed to evaluate one or more alternatives to eliminate the uncertainty. This could involve CAD modeling, simulation, building and testing physical units, or systematic trial and error. For instance, a process of experimentation could involve building physical test units of different material compositions to see which best dissipates heat from a new processor. This distinguishes true R&D from routine engineering where a known solution is simply being applied.

The Core Challenge for Hardware Startups: Which Prototype & Testing Costs Count?

Once a project meets the Four-Part Test, the next step is identifying the specific costs that can be included in your credit calculation. These are called Qualified Research Expenses (QREs) and fall into three main categories. For hardware startups, the 'supplies' category is often the most significant and the most misunderstood, directly impacting your potential for startup tax savings.

1. Qualified Wages

This includes the taxable wages paid to employees who are directly performing, supervising, or supporting the qualified research activities. You cannot claim 100% of an engineer's salary unless they spend 100% of their time on qualified R&D. You must make a reasonable allocation of their time to specific R&D projects. This includes not only the lead engineers designing the product but also employees directly supporting them, such as a lab technician who maintains testing equipment or a junior engineer who runs simulations.

2. Qualified Supplies

This category covers the cost of materials and supplies used or consumed in the R&D process. This is where a critical distinction for hardware companies arises: the difference between a supply prototype and a capital asset. A supply prototype is built to be tested, analyzed, and often destroyed during experimentation. Its costs are QREs. A prototype built for marketing, investor demos, or as a final sales model is generally considered a depreciable capital asset, and its costs do not qualify as supplies. A scenario we repeatedly see is a robotics company building a new warehouse bot:

• Version 1: A crude, breadboarded assembly to test a new navigation algorithm. The costs for sensors, motors, and raw materials are qualified supplies.
• Version 2: A more refined prototype with a custom chassis built to test durability and battery life under stress. The materials and third-party fabrication costs for this test unit are also qualified supplies.
• Version 3: A final, polished version with a full enclosure used for a trade show and investor pitches. This is likely a capital asset, and its costs are not qualifying supplies for the R&D credit.

The key is the prototype's purpose. If its purpose is to answer a technical question through testing, its costs are likely qualified. If its purpose is sales or demonstration, it is not.

3. Qualified Contract Research

You can include 65% of the amounts paid to third parties for performing qualified research on your behalf. A crucial rule is that contract research expenses are limited to work performed by US-based contractors. When working with fabrication shops or engineering consultants, it is important to have a Statement of Work (SOW) that clearly separates the costs for experimental R&D activities from non-qualifying costs like production tooling or routine manufacturing. The SOW should specify the technical uncertainties being addressed and the experimental process the contractor will undertake.

Documentation Without the Drama: What You Actually Need to Track

For a startup founder without a finance team, the thought of an IRS audit can be daunting. But assembling the required documentation does not need to be a massive compliance project. The key is “contemporaneous documentation,” which means capturing information as you go using the tools you already have, like Google Drive, Jira, and QuickBooks.

The reality for most Pre-Seed to Series B startups is more pragmatic: a few simple, consistent processes are better than a complex system that goes unused. Here is what you actually need to track:

• Projects: For each major R&D initiative, create a simple summary that informally addresses the Four-Part Test. A one-page document in Notion or Google Drive is sufficient. It should outline: 1) The technical uncertainty you were trying to solve (e.g., Can our new battery chemistry achieve a 500-cycle life without degrading more than 20%?). 2) The alternatives you tested (e.g., three different electrolyte formulas). 3) The results of your experiments, including failures. 4) The final conclusion.
• Expenses: Use the features in your accounting software to tag QREs. In QuickBooks, you can use Classes or Tags to mark specific vendor invoices, like a bill from a machine shop for a prototype part, as “R&D.” This makes it simple to run a report at year-end to sum your qualified supply and contractor costs. This creates an audit trail that directly connects expenses to your qualified projects.
• Time: Most startups do not use detailed timesheets. Instead, you can create a reasonable allocation method. Use your project management tool, like Jira or Linear, to see which engineers were assigned to qualified R&D projects. Based on those assignments, you can develop a percentage allocation for each employee’s wages for the year. A brief memo or email exchange confirming these allocations provides valuable supporting evidence for R&D credit eligibility.

How to Claim R&D Tax Credits for Hardware Startups: The Filing Process

Once you have identified your qualified projects and calculated the associated QREs, the final step is to claim the credit and receive the cash. For early-stage, pre-revenue companies, the most valuable path is the payroll tax offset, a key component of manufacturing tax incentives.

To be eligible, your company must be a 'Qualified Small Business' (QSB). The definition is very specific. Your company must have:

• Less than $5 million in gross receipts in the credit year, AND
• Is within its first five years of generating revenue.

If you meet these thresholds, you can apply your R&D credit against the employer's portion of Social Security taxes, up to a maximum of $500,000 per year. This provides a direct cash benefit, even if you have no income tax liability. For more details on eligibility, see the IRS page on the Qualified Small Business payroll tax credit.

To calculate the credit amount, most startups use the Alternative Simplified Credit (ASC) method. The Alternative Simplified Credit is calculated as 14% of the current year's qualified research expenses (QREs) that exceed 50% of the average QREs from the prior three years. This method is popular because it avoids the need for complex historical records from before your company may have existed.

The filing itself is a two-step process:

1. First, the R&D credit is calculated on Form 6765, Credit for Increasing Research Activities, filed with the annual corporate income tax return.
2. Then, to claim it against payroll, the payroll tax offset is claimed using Form 8974, filed with the quarterly payroll tax return, Form 941.

This process turns your R&D spending into a cash refund in the quarter after you file your income tax return, providing a valuable injection of non-dilutive funds.

Practical Takeaways

For hardware founders managing runway, the R&D tax credit is a direct way to recover a portion of your development costs. Getting started does not require an enterprise-level accounting system. The process can be broken down into four manageable steps.

First, qualify your projects. Run your core development work through the Four-Part Test. If you are solving a technical uncertainty through a process of experimentation, you are on the right track.

Second, focus on prototype costs. The biggest point of leverage is correctly identifying prototype development expenses as qualified supplies (for testing) versus non-qualified capital assets (for sales or marketing). This distinction can dramatically increase your QREs. When planning for the long term, consider how this fits with other incentives, such as our guide on QSBS tax benefits for investor outcomes.

Third, document as you go. Use your existing tools. A simple project memo in Notion and tagging expenses in QuickBooks is far more effective than trying to recreate records a year later.

Finally, file correctly to get the cash. For startups, the payroll tax offset for QSBs is the primary mechanism. Ensure your accountant is familiar with both Form 6765 for the annual return and Form 8974 for the quarterly payroll filing to ensure a smooth process from calculation to refund. For broader approaches and related credits, see our Tax Strategy hub.

Frequently Asked Questions

Q: Can I claim R&D credits if my project failed?

A: Yes, absolutely. A failed project is often strong evidence that you met the "Elimination of Uncertainty" and "Process of Experimentation" tests. The credit rewards the research process, not a successful commercial outcome. Documenting failures is a key part of substantiating your claim.

Q: What is the main difference between an R&D tax credit and a tax deduction?

A: A tax deduction reduces your taxable income, while a tax credit provides a dollar-for-dollar reduction of your actual tax liability. For startups, the R&D credit is powerful because it can be claimed against payroll taxes, generating a cash refund even if you have no income tax to pay.

Q: How do state R&D tax credits work with the federal credit?

A: Many states offer their own R&D tax credits, which can be claimed in addition to the federal credit. The rules and qualification criteria vary significantly by state. It is important to work with a tax advisor to understand your eligibility and claim both federal and state incentives for maximum startup tax savings.