R&D Expenses: Section 174A Deductions and the Section 41 Credit

Domestic research and development costs are once again fully deductible in the year you incur them, thanks to new Section 174A of the Internal Revenue Code enacted in 2025 under the One Big Beautiful Bill Act. The IRS rules for deductions and credits on R&D expenses now work on two tracks: a Section 174A deduction that reduces taxable income, and a separate Section 41 credit that reduces tax owed dollar-for-dollar. Foreign R&D is treated very differently and still must be capitalized and amortized over 15 years.¹

What Counts as a Research or Experimental Expense

A cost qualifies as a research or experimental expenditure if it relates to developing or improving a product, process, formula, or technique in a laboratory or experimental sense. The core requirement is technical uncertainty: the information available to you doesn’t establish whether the product can be developed, how it should be designed, or what method will work.² Whether the project ultimately succeeds or fails doesn’t matter.

Software development is explicitly included. Any amount paid or incurred to create or improve computer software is treated as a research or experimental expenditure.³ That sweeps in coding, software architecture and user interface design, quality assurance tied to development, deployment, and cloud hosting for the development environment. Configuring off-the-shelf software, ongoing maintenance, and customer support generally don’t qualify.

Several categories are excluded from the definition entirely, no matter how experimental they might feel:

Market research, consumer surveys, advertising, and sales promotions.
Routine product testing, efficiency surveys, and management studies.
Buying someone else’s patent, model, or production process.
The cost of land, buildings, or equipment that qualifies for depreciation on its own.
Spending to locate or evaluate ore, oil, gas, or other mineral deposits.

These exclusions apply even when the spending happens alongside legitimate research.²

Deducting Domestic R&D Under Section 174A

For tax years beginning after December 31, 2024, Section 174A permanently restores immediate expensing for domestic research and experimental expenditures.¹ If your R&D happens in the United States, you deduct qualifying costs in the year you pay or incur them. No capitalization schedule, no five-year amortization, no sunset date on the rule.

You have one optional alternative: elect to capitalize domestic R&D and amortize it over a period of no less than 60 months, starting in the month you first realize benefits from the research. This election makes sense in limited situations, such as when a company has net operating losses and wants to preserve deductions for a future profitable year. For most businesses, the immediate write-off is more valuable.

Foreign R&D Still Has to Be Capitalized

Section 174A does not extend to research performed outside the United States. Foreign R&D costs must be capitalized and amortized ratably over 15 years, with the amortization clock starting at the midpoint of the tax year the expense is paid or incurred.³ Your first-year deduction on a foreign R&D expense is roughly 3.33% of the total cost.

Selling, retiring, or abandoning property tied to foreign R&D before the 15-year period ends does not accelerate the remaining deduction. The unamortized balance keeps writing off on the original schedule.³ The gap in treatment creates a strong reason to track exactly where research activities physically occur. A software team coding in Austin gets immediate expensing. The same team relocated to Dublin triggers 15 years of amortization.

Recovering Costs You Capitalized During 2022–2024

From 2022 through 2024, all domestic R&D had to be capitalized over five years under the original TCJA changes.⁴ If you still have unamortized balances from those years, the OBBBA gives you two paths to recover them: deduct the full remaining balance in the first tax year beginning after December 31, 2024, or spread it ratably over two tax years starting with that same year. For a calendar-year business, that means writing off the full balance on your 2025 return or splitting it between 2025 and 2026.

Small businesses have an additional option. If your average annual gross receipts are $31 million or less under the Section 448(c) test, you may elect to apply Section 174A retroactively for 2022 through 2024 by filing amended returns. The deadline is the earlier of July 6, 2026, or the expiration of the statute of limitations for claiming a refund. Larger businesses cannot amend and must use the prospective transition rules.

Which Costs Get Allocated to R&D

Working out which costs belong in your R&D bucket is often the hardest part of compliance, because employees and resources typically split time between research and other activities. IRS Notice 2023-63 requires allocation based on a cause-and-effect relationship to research.⁵ Costs that count include:

Labor for employees and contractors who perform, supervise, or directly support R&D, including base pay, overtime, stock-based compensation, payroll taxes, benefits, and vacation pay.
Materials and supplies used or consumed in research, including non-depreciable tools and equipment.
Depreciation on property used in or directly supporting research, including equipment placed in service before the capitalization rules took effect.
Attorney fees for preparing and filing patent applications.
Rent, utilities, insurance, repairs, and security for spaces and equipment used in R&D.
Travel directly tied to performing research.

Costs from general administrative departments that only indirectly benefit R&D don’t get allocated. Interest on debt used to finance research is excluded, as are website hosting fees, domain registration, and costs for inputting content into a website.⁵ The line between “directly supports” and “indirectly benefits” is where most allocation disputes arise, so contemporaneous time-tracking matters.

The R&D Tax Credit Under Section 41

The Section 41 research credit is a separate benefit from the Section 174 deduction. The deduction reduces taxable income; the credit reduces tax owed. You can claim both, subject to a coordination rule discussed below.

The Four-Part Test

Section 41 is more demanding than Section 174. To qualify for the credit, each business component must pass all four parts of this test:

The research must aim to develop or improve the function, performance, reliability, or quality of a product, process, software, technique, or formula. Research related only to style, taste, or cosmetic factors doesn’t qualify.⁶
You must be trying to discover information that resolves uncertainty about capability, method, or design.
Substantially all activities must involve a systematic process of experimentation, meaning modeling, simulation, testing, or similar evaluation of alternatives.
The research must rely on principles of physical science, biological science, engineering, or computer science.

Each business component is evaluated separately, so one qualifying project can produce credits even if others at the same company wouldn’t pass.

Qualified Research Expenses

Only certain costs count as qualified research expenses (QREs). In-house expenses include wages for employees who directly perform or supervise qualified research, plus tangible, non-depreciable supplies consumed in the research. Contract research expenses are limited to 65% of amounts paid to outside parties for qualified research, and the taxpayer must bear the economic risk if the project fails.⁶ Work that wouldn’t have qualified in-house doesn’t become qualified just because you hired a contractor.

Calculating the Credit

Most taxpayers use the Alternative Simplified Credit method. The credit equals 14% of the amount by which current-year QREs exceed 50% of average QREs from the three preceding tax years. If you had zero QREs in any of those three prior years, the credit is 6% of current-year QREs.⁶ Once you elect this method, it applies to all future years unless the IRS consents to a change.

Payroll Tax Offset for Startups

A qualified small business that doesn’t yet owe federal income tax can elect to apply up to $500,000 of the credit per year against its share of employer payroll taxes.⁷ Up to $250,000 per quarter applies against the employer share of Social Security tax, and any excess applies against the employer Medicare share, with unused amounts carrying forward. To be a qualified small business, current-year gross receipts must be under $5 million, and you cannot have had gross receipts in any tax year before the five-year period ending with the current year.⁸ That effectively limits the payroll offset to businesses in their first five years.

Coordinating the Deduction and the Credit

You can’t take a full deduction and a full credit on the same R&D spending. Section 280C requires that your otherwise allowable deduction for domestic R&D be reduced by the amount of credit claimed.⁹ Spend $1 million on domestic R&D and claim a $50,000 credit, and your deduction drops to $950,000.

You can instead elect a reduced credit and keep the full deduction. Under that election, the credit is reduced by the credit amount multiplied by the maximum corporate tax rate (currently 21%). A $50,000 credit becomes $39,500, but you keep the entire $1 million deduction. The election is made on the return and is irrevocable for that year.⁹ Running the math on both options each year determines which produces the better after-tax result.

Filing, Documentation, and Penalties

The R&D credit is claimed on Form 6765, Credit for Increasing Research Activities, attached to your income tax return. Starting with tax years beginning after 2025, Section G of Form 6765 is mandatory for most filers. Section G requires detailed business-component reporting, listing at least 80% of your total QREs by component (up to 50 components) in descending order.¹ Two narrow exceptions apply: qualified small businesses claiming the payroll tax offset, and filers with $1.5 million or less in total QREs whose average annual gross receipts don’t exceed $50 million and who are filing an original return.

To change your accounting method for R&D expenditures, such as switching from the 2022–2024 capitalization method to immediate expensing under Section 174A, file Form 3115, Application for Change in Accounting Method. Automatic consent procedures apply to Section 174 changes, so individual IRS approval generally isn’t required.⁴ Ongoing amortization of foreign R&D is reported on Part VI of Form 4562.

Most R&D credit claims live or die on documentation. The IRS expects records that directly connect each claimed expense to a specific qualifying activity: project narratives explaining the technical uncertainty being addressed, contemporaneous time-tracking for employees whose wages make up your QREs, and written contracts with invoices and payment proof for any third-party research. For the deduction, keep records showing how you allocated employee time and overhead between research and other operations, using the cause-and-effect standard from Notice 2023-63.⁵

Improperly expensing costs that should be capitalized, or overclaiming the credit, can trigger accuracy-related penalties. The standard rate is 20% of the underpayment attributable to negligence or disregard of rules. The same 20% rate applies for a substantial understatement, which for corporations means an understatement exceeding the lesser of 10% of the tax due (or $10,000, if larger) and $10 million.¹⁰ Contemporaneous documentation is the most reliable defense.

State Tax Treatment May Differ

Federal and state treatment of R&D expenses don’t always match. More than a dozen states had already decoupled from the TCJA’s capitalization requirement and allowed their own immediate expensing during 2022–2024, while others conformed to the federal rules. Now that Section 174A has changed federal treatment again, each state’s conformity position determines whether you can expense R&D on your state return, must capitalize it, or face hybrid treatment. Check your state’s current conformity status before assuming federal treatment carries over.

1
Internal Revenue Service. Instructions for Form 6765 (Rev. December 2025)
2
eCFR. 26 CFR 1.174-2 – Definition of Research and Experimental Expenditures
3
Office of the Law Revision Counsel. 26 U.S. Code 174 – Amortization of Research and Experimental Expenditures
4
Internal Revenue Service. Revenue Procedure 2023-8 – Procedures for Changing Methods of Accounting for Specified Research or Experimental Expenditures
5
Internal Revenue Service. Notice 2023-63 – Specified Research or Experimental Expenditures
6
Office of the Law Revision Counsel. 26 U.S. Code 41 – Credit for Increasing Research Activities
7
Internal Revenue Service. Research Credit Against Payroll Tax for Small Businesses
8
Office of the Law Revision Counsel. 26 USC 41 – Credit for Increasing Research Activities
9
Office of the Law Revision Counsel. 26 USC 280C – Certain Expenses for Which Credits Are Allowable
10
Internal Revenue Service. Accuracy-Related Penalty