Understanding the Substantially All Rule: Maximizing R&D Tax Credit Under the 80% Rule

The Substantially All rule (also known as the 80% rule) is a critical concept when claiming R&D tax credits. Whether you’re evaluating employee wages or business components, knowing when and how the Substantially All rule applies can mean the difference between a valid claim and an audit risk.

In this article, we define the rule, show how it works with the IRS four-part test, explain its applications to wages and business components, cover exceptions like the shrink-back rule and offer guidance on documentation and compliance.

What Is the Substantially All Rule?

The Substantially All rule means that at least 80% of a particular expense, activity or component must qualify under the IRS’s criteria for R&D in order for the entire item (wage, business component, etc.) to be treated as eligible for the credit.

This rule doesn’t just apply to wages; it extends to business components such as software features, product parts or process improvements. If fewer than 80% of the related activities qualify under R&D rules, the entire component can be disqualified unless you apply the shrink-back rule.

Key Criteria: The IRS Four-Part Test

To qualify under the Substantially All rule, the relevant activities must meet the IRS four-part test:

1. Permitted Purpose – The project must aim to create or improve a product, process, software or method for functionality, performance, reliability or quality.

2. Elimination of Uncertainty – Must address uncertainty in design, capability, methodology or materials.

3. Technological in Nature – Must involve engineering, biology, chemistry, physics, computer science or similar fields.

4. Process of Experimentation – Involves experimenting with alternatives to resolve uncertainties.

If 80% or more of your activities tied to wages or to a business component satisfy these criteria, then the Substantially All rule allows more favorable treatment.

Application to Wages: The 80% Rule

• If an employee spends 80% or more of their work time on qualified R&D activities, 100% of their wages can be treated as qualified research expenses (QREs).

• If an employee spends less than 80% on R&D, only the portion of wages attributable to qualified activities may be claimed.

• Accurate time-tracking is essential. Record hours or days spent on R&D vs non-R&D tasks.

Example: An engineer in product development spends 85% of their time testing new materials under the four-part test. Under the Substantially All rule, the business may count the engineer’s full wages as QRE, even though 15% of time was non-R&D.

Business Components: What Must Substantially All Qualify

A business component includes any product, software feature, process, technique or invention being developed or improved. To apply the Substantially All rule:

• At least 80% of the work on that business component must meet all four parts of the IRS test.

• If fewer than 80% of component activities qualify, the component could be disallowed in full, unless you shrink back.

• Proper assessment and documentation of the component’s activities are key.

Example: A software company develops a feature with multiple sub-tasks. If 85% of those sub-tasks meet the four-part test, the whole feature may qualify. If only 50% do, the feature might be disqualified unless trimmed down.

The Shrink-Back Rule: Narrowing the Scope

The shrink-back rule allows you to reduce the business component’s scope so that the remaining work meets the Substantially All requirement.

• Identify which parts of the project qualify under the four-part test, and discard or separate the rest.

• Focus your claim only on the qualifying portion.

• This is especially useful for complex or multi-feature projects where not all work is research or experimental.

Why Substantially All Matters More Now

Recent updates to IRS Form 6765 and increasing audit scrutiny mean businesses must now provide more granular details.

• Forms and filings now ask for more detailed breakdowns of experimental expenditures.

• Misapplication of the Substantially All rule may lead to audit risk, denied credits or penalties.

Best Practices for Compliance and Documentation

To properly apply the Substantially All rule and reduce your risk:

• Maintain detailed time logs for employees showing hours spent on R&D vs. non-R&D tasks.

• For each business component, document activities to assess whether ≥80% satisfy the four-part test.

• Use the shrink-back rule when needed to isolate qualified work.

• Save all records of experiments, tests, designs, trial runs and iterations.

• Review R&D credit policy updates annually and consult experts for changes in tax law.

Working with an Expert

Navigating the Substantially All rule, and optimizing your R&D tax credit claim, can be complex. The team at James Moore specializes in helping businesses:

• Interpret the 80% rule properly for your wages and business components

• Ensure compliance with revised IRS forms

• Maximize R&D tax credit while minimizing risk

Contact a James Moore professional today to assess your eligibility under the Substantially All rule and see how these rules can work for your business.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.