Connecting R&D expenses to business components is a central part of substantiating an R&D tax credit claim. The IRS has noted that studies which fail to connect specific projects and activities to the underlying costs can fail to establish the required nexus. This page explains how to connect expenses to business components in a way that can help support a credit claim. It is educational and is not individualized advice. For the cost framework, see our page on qualified research expenses.
What a Business Component Is
Under Section 41, a business component may be a product, a process, software, a technique, a formula, or an invention. The research must relate to developing or improving a specific business component, and the analysis is applied at the business-component level. Connecting expenses to business components means linking each cost — wages, supplies, contract research — to the specific business component it supports. For more, see our page on qualified research.
The Nexus Requirement
The IRS has published guidance describing the information required for a valid Section 41 research credit claim for refund, including identifying the business components to which the claim relates, the research activities performed for each business component, and the total qualified expenses. The Instructions for Form 6765 reflect reporting by business component. The connection between activities, costs, and business components is part of what must be substantiated. For more, see our page on R&D tax credit documentation.
Connecting Wages to Business Components
For wages, connecting expenses to business components involves identifying which employees worked on which business components, what qualified services they performed, and how their time was allocated. Records that connect employees to specific projects and business components can help support the wage component. For more, see our page on wage allocation documentation.
Connecting Supplies to Business Components
For supplies, connecting expenses to business components involves identifying which materials were used in which qualified research activities and business components. Purchase and use records that tie materials to specific projects can help support the supply component. For more, see our page on supplies documentation.
Connecting Contract Research to Business Components
For contract research, connecting expenses to business components involves identifying which outside-party research relates to which business components. Engagement agreements and statements of work that tie the research to specific projects can help support the contract research component. For more, see our page on contractor documentation.
Connecting Experiments to Business Components
Experiments and tests should also be connected to business components. Test plans, test results, and experiment logs that identify which business component the testing relates to can help support the process-of-experimentation element and the connection between activities and the business component. For more, see our page on how to document a process of experimentation.
Hypothetical Example
Consider a manufacturer that is developing two new products — Product A and Product B — and has engineers, materials, and contractor costs associated with each. The documentation connects: the engineers' wages to Product A or Product B based on project assignments and time records; the materials to Product A or Product B based on usage records; the contractor costs to Product A or Product B based on engagement agreements and statements of work; and the experiments to Product A or Product B based on test plans. This organized record set — with each cost connected to a specific business component — can help support the credit claim.
By contrast, a record that pools all costs without connecting them to specific business components is less useful and may fail to establish the required nexus.
This example is illustrative only.
Key Takeaway
Connecting R&D expenses to business components involves linking each cost — wages, supplies, contract research — to the specific business component it supports. The IRS has noted that studies failing to establish this nexus can fail to substantiate a claim. Because nexus documentation is fact-specific, professional review is appropriate.