Summary: Many life sciences and pharmaceutical companies perform qualifying R&D but fail to capture the cash‑savings benefits available through the R&D tax credit. Claiming the credit can help offset taxes and free up capital to support drug development, clinical initiatives, and manufacturing innovation.
The pharmaceutical and life sciences industry faces a unique advantage in claiming the R&D tax credit compared to other industries. From discovery through commercialization, life sciences and pharmaceutical companies invest heavily in advancing innovative therapies, devices, diagnostics, and manufacturing processes. These development efforts often present scientific and technical uncertainty that require extensive experimentation, evolving hypotheses, and rigorous testing grounded in scientific principles—all core elements of the R&D credit framework.
The R&D tax credit provides tremendous benefits to companies every year with dollar-for-dollar offsets against taxes owed or paid. Any company that engages in experimental activities to invent or improve a product, process, software, technique, or formula may be eligible for the R&D tax credit. For life sciences and pharmaceutical companies, R&D tax credit eligibility often extends far beyond early ideation and lab testing, potentially offering substantial cash savings on work performed throughout the entire development cycle.
What is the R&D Tax Credit?
Section 41 of the Internal Revenue Code (IRC) established the R&D tax credit in 1981 as a tax incentive for U.S. businesses, regardless of size or industry, that incur expenses related to developing or improving products, processes, software, or techniques. R&D for the purposes of the tax credit must meet each component of the 4-part test:
- Permitted Purpose: The activity seeks to develop a new or improved product or process, or to enhance functionality, performance, reliability, quality, or safety.
- Technological in Nature: The activity relies on principles of biology, chemistry, biochemistry, pharmacology, engineering, or other physical or biological sciences.
- Elimination of Uncertainty: At the outset, there is uncertainty regarding how to achieve the desired result, whether it can be achieved, or which approach will ultimately succeed.
- Process of Experimentation: The company evaluates alternatives through systematic trial and error, such as hypothesis testing, controlled studies, iterative refinement, and analysis of results
Given the breadth of these components, companies that innovate on drugs, biologics, medical devices, diagnostics, and related manufacturing processes can often capture qualified research expenditures (QREs) and qualified research activities (QRAs) associated with a product or process’s development cycle. Let’s take a closer look at potential QRAs.
Common Qualifying Activity Areas Under the R&D Tax Credit
Drug Discovery & Pre-Clinical Development
Life science companies frequently perform pre-clinical research to identify and optimize compounds or biologics and face uncertainty around biological response, dosing, stability, or feasibility. Research activities associated with identifying new indications and applications for existing biologics and compounds can also qualify for the credit. To resolve this uncertainty, teams perform iterative experimentation such as:
- Target identification and validation
- Compound screening and optimization
- Structure activity relationship (SAR) studies
- In vitro and in vivo testing
- Development of assays, biomarkers, or testing methodologies
Clinical Trial Activities (Phases I-III)
The design, execution, and evaluation of clinical trials can be qualified. Examples of QRAs may include:
- The design of trial protocols and study methods
- Definition of dosing strategies and inclusion/exclusion criteria
- Analysis of trial results and interim data
- Refinement of protocols in response to challenges
- Evaluation of alternative formulas, delivery mechanisms, or treatment regimens
Formulation, Delivery & Product Development
Developing stable, safe, and effective drug formulations and delivery systems can present companies with technical challenges and uncertainties around absorption, manufacturability, or shelf life. Potential qualifying activities may encompass:
- Development and testing of alternative formulations to improve bioavailability or stability
- Evaluation of excipients and preservatives
- Design of controlled release or targeted delivery systems
Process Development & Manufacturing R&D
Life sciences companies often conduct extensive research to develop or improve:
- Manufacturing workflows, scale processes from lab to pilot to commercial production
- Address yield, purity, contamination, or reproducibility challenges
- Develop or refine quality control and testing procedures
Laboratory Operations Supporting R&D
Laboratory support activities integral to experimental research (rather than general facility maintenance) can qualify, including any:
- Lab sanitization and preparation
- Equipment setup, calibration, and teardown
- Material handling, preparation, and disposal performed for experimental work
Defining Specifications
Experimentation performed to meet evolving regulatory standards and product requirements, such as:
- Defining product specifications and quality attributes for uncertain outcomes
- Developing testing protocols to demonstrate safety, efficacy or compliance
- Addressing regulatory feedback that requires additional experimentation or redesign
These example scenarios are certainly not exhaustive of potential QRAs, and companies should note that the success and/or completion of a product or process is not a requirement for the R&D tax credit. In fact, failures can even be great examples of R&D if they demonstrate the challenges related to the technical uncertainty and complexity associated with a project’s technical objectives.
However, understanding which activities qualify is only part of the R&D equation. Companies must also consider and be careful to exclude activities that do not qualify. Efforts related to marketing, patient care, consumer behavior analysis, aesthetic improvements, and routine lab or manufacturing procedures are not eligible; therefore, any costs associated with these activities must be excluded from the credit calculation.
Four R&D Cost Categories
For purposes of the R&D tax credit, only four specific cost categories, or QREs, may be included in the credit calculation, though not all four categories will be applicable for every industry or company. QRE categories include:
- Wages – Compensation for employees who directly perform, supervise, or support qualified R&D activities in the United States (e.g., scientists, clinicians, engineers, lab managers, and technical leadership)
- Supplies – Tangible supplies used and consumed during R&D activities, including lab materials, trial supplies, and prototype materials (excluding capital equipment)
- Contract Research – A portion of amounts paid to third-party CROs, labs, or contractors performing qualified research in the United States on the company’s behalf
- Computer Rental Costs
Other Considerations for the R&D Tax Credit
Beyond the identification of QREs and QRAs, the R&D tax credit requires taxpayers to provide and gather a few more key details that should be gathered alongside an experienced R&D credit advisor. For instance, beginning in the 2026 tax year, the IRS will require companies to provide details at a business component level on Form 6765. This level of specificity has never previously been required, and companies should enlist the guidance of a trusted tax professional who can help to ensure business components are properly defined and reported on the form.
The R&D tax credit also requires supporting documentation to substantiate the experimentation performed. Though claiming the credit on original returns will not increase a company’s risk of an audit, the IRS and Department of Revenue (DOR) examiners may request contemporaneous documentation if the credit is selected for examination. Documentation may include:
- Experimental data comparing candidate compounds or formulations
- Internal communications discussing scientific uncertainty and hypotheses
- Materials demonstrating iterative testing of alternative approaches to improve safety, efficacy, stability, or manufacturability
There are additional credit opportunities for companies performing research activities to develop drugs for certain rare diseases, which the FDA has designated as “Orphan Drugs.” The Orphan Drug Credit allows for foreign Contract Research Organizations (CROs) and clinical trials if the reason is because the disease is too rare to find a large enough population in the USA to participate in clinical trials.
Final Thoughts: Turn Your Development Costs into Tax Savings
Life sciences and pharmaceutical companies often perform substantial R&D throughout the product lifecycle that are likely to qualify for the R&D tax credit. The activities and costs from discovery through clinical development and manufacturing may generate substantial tax credit opportunity.
With thoughtful analysis, defensible documentation, and clear associations between activities and related costs, companies can unlock significant cash savings. Enlist the help of an R&D tax credit specialist to learn how your business can benefit from the credit today.
