R&D Tax Credit Calculation: How to Separate Internal and External Costs

Understanding How to Separate Internal and External Costs for the R&D Tax Credit

For early-stage SaaS, Biotech, and Deeptech founders, every dollar of runway counts. You meticulously track expenses in QuickBooks for survival, not for complex tax optimization. Yet, the R&D tax credit represents a significant, non-dilutive source of capital that too many startups underclaim out of confusion. The core challenge often boils down to one question: how to separate internal and external costs for the R&D tax credit in a way that maximizes your claim without creating an administrative nightmare.

Anxiety about IRS pushback is real, especially when you lack a dedicated finance team. This guide provides a practical framework for categorizing your R&D spend correctly, ensuring you can confidently claim the credit you’ve earned for your innovation.

The Two Buckets of R&D Spending: Internal vs. External Costs

To properly calculate your R&D tax credit, you must understand its foundational components. For US-based startups, Qualified Research Expenses (QREs) primarily fall into two categories: Internal Costs, which are wages paid to your direct employees, and External Costs, which include payments to contractors and for certain cloud services. This distinction is not just academic; it has a direct and significant impact on the size of your credit.

The primary reason this separation is so critical relates to how each dollar is treated by the IRS. Employee wages for qualified services are generally 100% claimable. This includes salaries, bonuses, and even qualifying stock-based compensation for time spent on R&D. In contrast, payments to US-based contractors are generally limited to 65% of the total cost for the credit calculation. Getting this classification wrong means either leaving money on the table or overclaiming and risking future penalties. Mastering this simple categorization is the first step toward maximizing your credit.

Section 1: Internal Costs and R&D Payroll Allocation

Internal costs, centered on your direct employees, form the backbone of most R&D credit claims. Capturing these qualifying R&D expenses accurately requires looking beyond just the payroll reports in Gusto or Rippling and understanding how your team's time is actually spent. The IRS provides two primary methods for this. See the IRS Form 6765 instructions for official guidance.

The 'Substantially All' Rule: A Powerful Shortcut

The first method is a powerful shortcut called the 'Substantially All' Rule. This rule states that if an employee spends 80% or more of their time on qualified R&D activities, you can include 100% of their wages for that period in your claim. This is a huge benefit for roles that are inherently focused on technical problem-solving, such as dedicated software engineers, lab scientists, or hardware developers. For these individuals, you do not need to track every single hour. As long as you can substantiate that they meet the 80% threshold, their entire compensation qualifies.

Qualified activities include hands-on development, direct supervision of technical staff, and direct support of the research process, such as setting up a testing environment. It does not include general administrative duties or marketing activities.

Allocating Time for Mixed-Role Employees

The reality for most early-stage startups is more nuanced because many key employees wear multiple hats. A CTO might spend 60% of their time writing code, 20% supervising junior developers, and 20% in investor meetings. For any employee who falls under the 80% threshold, you need a reasonable, documented allocation of their time. You must separate qualified activities from non-qualified ones.

The key is to establish a consistent methodology. What founders find actually works is a simple system for tracking this allocation, often using project tags in Jira to associate time with R&D epics or a basic spreadsheet updated monthly by managers. This creates the contemporaneous record the IRS looks for. Consider this allocation for a startup CTO:

• Writing and debugging new feature code (50%): Qualified. This is direct R&D work.
• Direct supervision of the engineering team (20%): Qualified. Supervising those conducting R&D is a qualifying activity.
• Technical planning for the next sprint (10%): Qualified. This is part of the direct R&D process.
• Investor presentations and fundraising (15%): Not qualified. This is a general business activity.
• General administrative tasks (5%): Not qualified.

In this scenario, 80% of the CTO's wages (50% + 20% + 10%) can be included in the R&D credit calculation.

Don't Forget Stock-Based Compensation

Finally, remember to include stock-based compensation. For your R&D team members, the allocated portion of this non-cash expense is a valid QRE. The qualifying amount is the expense recognized for accounting purposes under ASC 718. In highly compensated tech roles, this can add significant value to your credit claim without impacting your cash flow.

Section 2: External Costs from Contractors and Cloud Services

While internal wages offer a 100% inclusion rate, external costs from contractors and vendors are also a crucial part of qualifying R&D expenses, albeit with more stringent rules. For any external vendor R&D tax claim, you must be prepared to demonstrate its direct link to your research and development efforts.

The Three Tests for Subcontractor Costs and R&D Credit

For payments to US-based contractors, the claimable amount is capped at 65% of the cost, and the work must pass three specific tests. Per IRS guidelines on contract research expenses, the arrangement must satisfy these conditions:

1. Qualified Purpose: The work performed by the contractor must be for a qualified research purpose. In other words, the activities would have qualified for the credit if your own employees had performed them.
2. Substantial Rights: Your company must retain substantial rights to the research results and intellectual property created. If the contractor owns the IP, the expense does not qualify.
3. Financial Risk: Your company must bear the financial risk of failure. This is a critical point. If your contract states you only pay upon successful completion of the project, the risk is on the contractor, and the expense is likely disqualified. If you pay for their effort regardless of the outcome, you bear the risk.

Pay close attention to your Statement of Work (SOW) to ensure compliance. A well-drafted SOW is your primary evidence. A weak clause might state, "Contractor will develop a proprietary algorithm. Payment is conditional upon successful validation, and Contractor retains all rights." This fails both the rights and risk tests. A strong clause would be, "Client will pay Contractor for services rendered in developing a new algorithm. Client shall own all rights, title, and interest in all work products. Payment is tied to project milestones, not the commercial success of the outcome."

Cloud Computing: Qualifying IaaS and PaaS Expenses

A significant and recent change involves cloud computing. As of 2022, amounts paid for cloud services like Infrastructure as a Service (IaaS) and Platform as a Service (PaaS) can be included as a QRE if used for qualified research. This is a major development for SaaS and Deeptech startups that rely on providers like AWS, GCP, and Azure for development, testing, and staging environments.

However, this does not cover all software. General business SaaS subscriptions such as Slack or Salesforce do not qualify. The key distinction is between raw infrastructure used for development versus finished software tools used for operations. The best practice for documenting r&d spend here is to use resource tagging within your cloud provider. By tagging servers and databases with labels like "Development," "Staging," and "Production" in AWS Cost Explorer or a similar tool, you can easily isolate and document the qualifying expenses.

Section 3: Building a 'Good Enough' System for Contemporaneous Documentation

One of the biggest sources of anxiety for founders is the fear of an IRS audit. The key to mitigating this fear is to build a documentation system that is 'contemporaneous, not perfect'. The IRS wants to see that you were tracking R&D activities as they happened, not trying to piece together a story two years later. You can achieve this with the tools you already use.

Documenting Internal Payroll and Time Allocation

For internal costs, your existing systems are the foundation. Payroll records from QuickBooks or Gusto establish the wage base. The time allocation piece can be supported by your project management data. If your engineers log hours against specific tickets in Jira tagged as "New Feature Development" or "Experimental Research," you have a contemporaneous record of their qualified time. For less formal environments, a simple spreadsheet where managers note their team's allocation quarterly can be sufficient, as long as it's maintained consistently.

Creating a Paper Trail for External Costs

For external costs, the paper trail is paramount. Every contract and SOW with a third-party developer should be saved and should clearly outline the R&D nature of the work and the 'rights and risk' clauses. When paying invoices through Bill.com or your bank, make a habit of annotating the payment with the relevant project name. For cloud costs, your tagged billing reports from AWS or GCP are your primary source documentation. Exporting these reports quarterly provides a clear, time-stamped record of your qualifying cloud spend. The goal is not to create a mountain of paperwork, but a logical, consistent trail that connects expenses to projects.

Practical Takeaways for Maximizing Your R&D Credit

Navigating how to separate internal and external costs for the R&D tax credit does not require a dedicated finance department, just a disciplined approach. By implementing a simple system now, you can maximize your R&D tax credit eligible costs and build a defensible position for the future.

Remember these core principles:

• Internal vs. External is Key: Employee wages are generally 100% claimable, while contractor costs are limited to 65%. Classify them correctly from the start.
• Use the 80/100 Shortcut: For team members spending over 80% of their time on R&D, you can include 100% of their wages without detailed time tracking.
• Apply the Three Contractor Tests: Ensure your contracts confirm a qualified purpose, that you retain substantial rights, and that you bear the financial risk.
• Tag Your Cloud Spend: Systematically isolate qualifying IaaS and PaaS costs (dev, staging) from non-qualifying SaaS and production expenses using tags.

Starting this process today will turn a daunting task into a manageable routine, converting your innovation into valuable, non-dilutive cash. For more information, visit our R&D Tax Credit Process & Documentation hub.

Frequently Asked Questions

Q: Can I include payments to foreign contractors for the R&D credit?
A: Generally, no. For contract research expenses to qualify for the US R&D tax credit, the research activities must be conducted within the United States, its territories, or its possessions. Payments to offshore contractors for work performed outside the US are typically excluded from the calculation.

Q: What counts as 'direct supervision' for an employee's time?
A: Direct supervision involves the immediate oversight of individuals performing qualified research. This includes activities like leading technical planning meetings, conducting code reviews, or managing scientists in a lab. It does not include high-level administrative management, such as HR duties or general departmental budgeting.

Q: Are production server costs from AWS eligible for the R&D credit?
A: No, cloud computing costs associated with hosting a live, commercial product for customers (production environments) are not considered qualified research expenses. Only costs for infrastructure used directly for development, testing, and staging activities related to creating new or improved products are eligible.

Q: Do I need to track my employees' R&D time on a daily basis?
A: Daily time tracking is not required. The IRS looks for a reasonable and consistent allocation method. For employees who fall under the 'substantially all' (80%+) rule, no detailed tracking is needed. For others, a consistent project-based allocation done on a monthly or quarterly basis is typically sufficient.