Research Credit (R&D Tax Credit)

The federal research credit, often called the R&D credit, rewards businesses that spend money developing new or improved products, processes, software or formulas. It is not limited to scientists in labs. Manufacturers, software developers, engineers and food or product developers can qualify. For some young companies, the credit can even be used against payroll taxes instead of income tax. This guide explains how it works for 2025 returns and what changes for 2026.

The four-part test

Research qualifies only if all four of these are true. The test is applied to each business component (a product, process, software, technique, formula or invention).

1. Eligible expense. The costs are domestic research or experimental expenditures under Section 174A.
2. Technological in nature. The research relies on engineering, computer science, physical or biological sciences.
3. New or improved business component. It is intended to be useful in developing a new or improved component.
4. Process of experimentation. Substantially all of the activities are elements of a process of experimentation to evaluate alternatives, aimed at new or improved function, performance, reliability or quality.

Several activities are excluded: research after the product is commercially available, duplicating an existing component, surveys and studies, research done outside the United States, and research funded by someone else.

What counts as a qualified expense

• In-house wages for employees who perform, supervise or directly support qualified research
• Supplies used in the research
• Computer rental or lease costs
• Contract research, generally 65 percent of amounts paid to others

Costs unrelated to experimentation, such as routine testing, general administration and marketing, are not QREs.

How the credit is figured

Taxpayers can compute the credit one of two ways and use the larger result:

• Regular credit. 20 percent of QREs above a base amount.
• Alternative simplified credit (ASC). A percentage of QREs above half of the average QREs for the prior three years. An election to use the ASC applies to the year and later years.

Section 280C(c) election. To avoid reducing the research deduction by the credit amount, you can elect a reduced credit. The reduced credit is 15.8 percent in the regular method, and 79 percent of the ASC amount. Under Section 174A, domestic research deductions are reduced by the credit amount unless you make this election on a timely filed original return, including extensions. It cannot be made or changed on an amended return and is irrevocable for the year.

The payroll tax election for small businesses

A qualified small business can elect to apply up to $500,000 of research credit per year against payroll tax rather than income tax. This is useful for startups with no income tax to offset. The conditions are:

• Gross receipts under $5 million for the tax year.
• No gross receipts in any tax year before the five-year period that ends with the current year. In plain terms, the business must be early in its revenue-producing life.
• No more than five tax years with the election.

You make the election on Form 6765 by the due date of the original return, including extensions. You then claim the credit on Form 8974 with the first quarterly employment tax return that begins after you file the election. See Form 941 for the quarterly filing.

Documentation

The IRS expects records that show what was tried, by whom, and what it cost. Useful documentation includes project lists, technical notes, test results, time tracking, payroll records and invoices for contract research. If you use statistical sampling, the instructions point to Revenue Procedure 2011-42 and require a sampling plan to be kept. Amended returns claiming or increasing the credit must include additional required information for the claim.

Beginning with tax years that begin after 2025, Section G of Form 6765 is required. It asks you to report at least 80 percent of total QREs by business component, with up to 50 components shown and the remainder aggregated. Plan to collect project-level data during the year, not after it.

Interaction with the 2025 research deduction law

The One Big Beautiful Bill Act restored current deductions for domestic research costs under Section 174A for tax years beginning after 2024. See start-up costs and research expenses. The credit and the deduction are separate benefits, but they are coordinated: electing the reduced credit avoids the deduction reduction. States may have their own research credits as well.

Common mistakes

• Treating all payroll for technical staff as qualified.
• No contemporaneous records, so the credit cannot be supported.
• Forgetting the Section 280C election on the original return.
• Missing the payroll election deadline.
• Claiming credit for work a customer funds under a contract that pays you whether or not the research succeeds.

How we can help

We can look at whether your development work is likely to pass the four-part test, help organize records, prepare Form 6765 and the payroll election, and coordinate the credit with your deduction choices. See our tax planning and business tax preparation services, or contact us.

Frequently asked questions

General information only, not tax, legal or accounting advice for your situation. Rules, limits and deadlines change; confirm the current rules with the official source or a qualified professional before you act. Reading this page does not create a professional relationship with CPA Tax Payroll and Accounting Corp.