Under Treas. Reg. 1.41-4(b)(2), the requirements for qualified research are applied first to the whole business component: the product, process, computer software, technique, formula or invention. Only if the whole component fails do they apply to the most significant subset of its elements, and then to successively smaller subsets, until a subset qualifies or the most basic element fails. The rule works from the top down, and the regulation states that it is not itself a reason to exclude research activities from credit eligibility.
How the Rule Works
Start with the component. Section 41(d)(2)(A) applies the qualified research tests separately to each business component. Treas. Reg. 1.41-4(b)(2) begins “at the level of the discrete business component,” whether it is held for sale, lease or license or used in the taxpayer’s trade or business. Our guide to the four-part test covers the four requirements themselves.
Shrink only after a failure. The rule is applied only if the taxpayer does not satisfy the requirements for the overall business component. If the whole component qualifies, the analysis stops there. If it does not, the tests move to the most significant subset of elements, and the shrinking continues until a subset satisfies the requirements or the most basic element is reached and fails.
It does not work upward. The analysis begins at the component and moves down. A qualifying subset does not make the rest of the component qualify; generally, only the research relating to the subset that meets the tests is qualified research. And because the regulation says the rule “is not itself applied as a reason to exclude research activities from credit eligibility,” it does not let the rule be used to carve research out of a component that qualifies as a whole.
The process stays separate. Section 41(d)(2)(C) treats a plant process, machinery or technique for commercial production as a business component separate from the product, and Treas. Reg. 1.41-4(b)(1) tests product and process activities without regard to each other. The shrinking-back rule then runs within each component. Our article on manufacturing process improvement shows how that plays out on a production line.
The Regulation’s Example: An Engine and a New Carburetor
The facts. In the illustration in Treas. Reg. 1.41-4(b)(3), a motorcycle engine builder develops a new carburetor for use in a motorcycle engine and modifies an existing engine design for use with the new carburetor.
The analysis. The tests are applied first to the engine, which is the business component. If the engine modifications, viewed as a whole together with the new carburetor, do not meet the requirements, the tests are applied to the next most significant subset. The example assumes that subset is the carburetor and concludes that the research on the carburetor may be qualified research.
In plain terms. The engine is where the analysis starts. If adapting the existing engine design was largely routine, the engine as a whole may fail, and the rule then lets the carburetor be tested on its own and qualify even though the engine project did not. The example does not say why the engine fails; it assumes that it does.
The section 174 regulations take a parallel approach. Treas. Reg. 1.174-2(a)(5) determines whether costs are research expenditures at the level of the component or subcomponent if the requirements are not met at the level of the product, and it also states that the rule is not itself a reason to exclude expenditures.
How the Rule Interacts With the 80 Percent Test
The substantially-all requirement is measured component by component. Under Treas. Reg. 1.41-4(a)(6), the requirement is met only if 80 percent or more of a taxpayer’s research activities, measured on a cost or other consistently applied reasonable basis, constitute elements of a process of experimentation for a qualified purpose. The remaining 20 percent or less must still satisfy section 41(d)(1)(A) and not be otherwise excluded. The requirement is applied separately to each business component.
Shrinking back changes what is measured. A component can fail the substantially-all requirement because its experimentation is concentrated in one part while most of the work elsewhere is routine. Testing a subset narrows the activities in the measure. The figures below are a hypothetical illustration on a cost basis.
| Level tested | Research activity costs | Experimentation costs | Share |
| Engine (whole component) | $1,000,000 | $500,000 | 50% |
| Carburetor (subset) | $400,000 | $340,000 | 85% |
In this illustration the engine fails the 80 percent measure and the carburetor subset meets it. The carburetor’s research activities, including the $60,000 that is not experimentation if it satisfies section 41(d)(1)(A) and is not excluded, may be qualified research; the other $600,000 of engine activity is not. The other requirements of the four-part test must also be met at the subset level.
Defining Business Components in a Study and on Form 6765
How components are set. The starting point is what the company sells or uses: each product, process, piece of software, technique, formula or invention is a candidate business component, with production processes listed apart from the products they make. The Form 6765 instructions ask that each component’s name or identifier be “consistent with how you maintain the books and records that substantiate the qualified research activities.” Where a component fails as a whole, the file should show the subset analysis. Our overview of the R&D tax credit study process describes how a study is organized.
What Form 6765 asks. On Form 6765 (Rev. December 2024), Section E, line 37 asks for the total number of business components generating the QREs on line 48, not just those reported in Section G. Section G is optional for tax years beginning before 2026. For tax years beginning after 2025 it is required unless the filer is a qualified small business claiming the payroll tax credit, or the controlled group’s QREs are $1.5 million or less, average annual gross receipts for the prior three tax years are $50 million or less, and the credit is reported on an original return (Instructions for Form 6765, Rev. December 2025).
What Section G reports. Filers list business components covering at least 80 percent of total QREs, but no more than 50 components, in descending order of QREs, and report the rest as “Aggregate Business Components.” For each listed component, columns 49(a) to 56 report the entity’s EIN and business activity code, the component’s name or identifier, its type, a software classification where relevant, wages split among direct research, direct supervision and direct support, supplies, computer rental and contract research. Column 49(f) is required for certain research credit claims on amended returns and not for timely filed original returns, including extensions. Our Form 6765 guide walks through the rest of the form.
Two different 80 percent figures. The Section G threshold is a reporting rule about how much of total QREs is itemized by component. The substantially-all requirement is a qualification rule about the share of a component’s research activities that are experimentation. The instructions do not say how a component that qualifies only at a subset level should be named in Section G; their stated standard is an identifier consistent with the books and records.
If you want to see how your projects break down into business components and subsets, you can request a no-cost analysis from CSSI Services or read more about our R&D tax credit services.
Frequently Asked Questions
What is the shrinking-back rule?
It is the rule in Treas. Reg. 1.41-4(b)(2) for applying the qualified research tests. They are applied first to the whole business component and, only if it fails, to the most significant subset of its elements and then to smaller subsets, until one qualifies or the most basic element fails.
Can the shrinking-back rule be used to exclude research?
The regulation states that the rule is not itself applied as a reason to exclude research activities from credit eligibility. It is applied only when the overall business component does not meet the requirements.
Can a company start the analysis with a subset?
The regulation applies the requirements first at the level of the discrete business component and moves to a subset only if the component as a whole does not qualify.
How does the rule relate to the 80 percent substantially-all test?
The substantially-all test is applied separately to each business component. If a whole component falls below 80 percent, shrinking back can bring the test to a subset where experimentation makes up 80 percent or more of the research activities, measured on a cost or other consistently applied reasonable basis, and the other requirements must also be met there.
Does Form 6765 ask about subsets?
The instructions do not mention the shrinking-back rule. Section G, required for tax years beginning after 2025 unless an exception applies, reports QREs by business component, using an identifier consistent with the company’s books and records.
This article provides general information about federal tax rules and is not tax advice. Speak with your tax adviser about your specific circumstances.
