R&D Tax Credit Legislation: Section 174A and Payroll Offset

Federal R&D tax credit legislation runs on two connected statutes: Section 41 of the Internal Revenue Code, which provides the credit itself, and Section 174A, a new provision created by the One Big Beautiful Bill Act on July 4, 2025, that restored immediate deduction of domestic research costs. The credit has been permanent since the PATH Act of 2015, but the deduction side of research spending was scrambled by the Tax Cuts and Jobs Act, which forced five-year amortization of domestic research starting in 2022. The 2025 law reversed that for tax years beginning after December 31, 2024, and gave businesses a way to recover the deductions they lost in the interim.

What Section 41 Rewards

Section 41 gives a credit for increasing qualified research spending in the United States, and it is calculated on Form 6765 using one of two methods.¹

The regular credit equals 20 percent of current-year qualified research expenses above a base amount tied to research spending and gross receipts from 1984 through 1988.² Because the base period predates most modern companies, this method is often impractical.

The alternative simplified credit (ASC) equals 14 percent of the amount by which current-year qualified research expenses exceed 50 percent of the average for the prior three years. A company with no research expenses in any of the prior three years can still claim a credit worth 6 percent of current spending. Most filers use the ASC and, once elected, generally stay with it.

Qualified research expenses fall into three buckets: wages for employees who perform, supervise, or directly support the research; supplies consumed in the process; and payments to outside contractors. Only 65 percent of standard contract research payments count toward the credit; payments to qualified research organizations such as universities count at 75 percent.²

What Qualifies as Research

Section 41(d) defines qualified research through a four-part test that is applied separately to each product, process, software application, or technique being developed.² The activity must:

Qualify as a research or experimental expenditure eligible for treatment under Section 174A.
Be technological in nature, relying on engineering, physical science, biological science, or computer science.
Be aimed at discovering information intended to develop a new or improved business component for the taxpayer.
Involve a process of experimentation for substantially all (interpreted by Treasury as 80 percent or more) of the activities, directed at a new or improved function, performance, reliability, or quality.

The experimentation prong is where claims most often break down. The IRS looks for genuine technical uncertainty about capability, methodology, or design, and a systematic evaluation of alternatives. Applying known techniques to a routine problem does not qualify, and uncertainty about whether a project will be profitable is not the kind of uncertainty the statute recognizes.

Section 41(d)(4) then carves out categories that never qualify, even when they look technical: research after commercial production begins, adaptation to a particular customer’s needs, reverse engineering, surveys and routine data collection, routine quality control, style and cosmetic work, social sciences, arts and humanities, research funded by another party, and research conducted outside the United States, Puerto Rico, or a U.S. possession.³

Software built primarily for a company’s own internal use faces an additional “high threshold of innovation” test under Treasury regulations implementing Section 41(d)(4)(E). It must be innovative in a substantial and economically significant way, involve significant economic risk, and not be commercially available for the intended purpose. Software built for customers or embedded in products sold to them is generally not treated as internal use and does not carry the extra test.

Section 174A and the 2025 Expensing Reset

The Tax Cuts and Jobs Act of 2017 required businesses, starting with tax years beginning after December 31, 2021, to capitalize research costs and amortize them over five years for domestic research and fifteen years for foreign research.⁴ The Section 41 credit still applied on top of those amortized deductions, but the amortization rule raised effective tax bills for research-heavy companies. An earlier attempt to reverse it, the Tax Relief for American Families and Workers Act (H.R. 7024), passed the House in early 2024 but stalled in the Senate.⁵

The One Big Beautiful Bill Act, signed July 4, 2025, created new Section 174A and permanently restored full expensing for domestic research and experimental expenditures for tax years beginning after December 31, 2024. Businesses may deduct these costs in the year paid or incurred, or elect to capitalize and amortize them over at least 60 months if that suits their tax planning. Software development costs are explicitly treated as research expenditures under Section 174A, which resolves a longstanding gray area.

Foreign research is not covered. Those costs remain subject to mandatory 15-year amortization under Section 174(d), the same treatment the TCJA imposed.⁶

Recovering 2022–2024 Amortized Costs

Many businesses still carry unamortized domestic research costs from the 2022 through 2024 tax years on their books. The OBBBA offers two ways to clear those balances faster.

Any taxpayer, regardless of size, may elect to deduct the remaining unamortized domestic research expenses from 2022–2024 either entirely in the first tax year beginning after December 31, 2024, or evenly across two tax years starting in 2025.⁶ The election is treated as a taxpayer-initiated change in accounting method, applied on a cut-off basis with no Section 481(a) adjustment.

Small businesses get a second, better option. A taxpayer with average annual gross receipts of $31 million or less, measured under the Section 448(c) test for the first tax year beginning after December 31, 2024, may elect to apply Section 174A retroactively to domestic research expenses paid or incurred in tax years beginning after December 31, 2021. This route requires amending each affected return, and the deadline is the earlier of July 6, 2026, or three years from the date the original return was filed.⁶ For qualifying companies, retroactive treatment can produce meaningful refunds.

Payroll Tax Offset for Startups

A credit against income tax is worth nothing to a company that owes no income tax. Section 41(h) lets certain qualified small businesses apply up to $500,000 of their R&D credit each year against the employer share of Social Security payroll taxes.⁷

Both of two conditions must be met: gross receipts of $5 million or less for the tax year, and no gross receipts in any tax year more than five years earlier. The $500,000 cap took effect for tax years beginning after December 31, 2022, replacing the previous $250,000 limit under the Inflation Reduction Act of 2022.⁷ The election is made on Form 6765 and applies starting the quarter after the return is filed.

Claiming the Credit and Amending Prior Returns

Form 6765 attaches to the annual federal income tax return: Form 1120 for C corporations, Form 1065 for partnerships, and Form 1120-S for S corporations, with pass-through owners picking up their share on their individual returns.¹

Claims added by amendment carry heightened information requirements. Any amended return seeking a new or increased R&D credit must include:

Identification of every business component the claim relates to for that year.
A description of the research activities performed for each component.
The names, titles, or positions of the individuals who performed each activity.
A description of the information each individual sought to discover.
Total qualified employee wage, supply, and contract research expenses for the claim, which can be satisfied through Form 6765 itself.⁸

Amended claims missing any of the five are routinely rejected or delayed. Given the catch-up opportunities under the OBBBA, many businesses are amending 2022–2024 returns now, and the five-item rule applies to those filings.

State Conformity Is Not Automatic

The federal changes do not automatically flow through to state income taxes. States with rolling conformity adopt federal code changes as they occur; states with fixed-date conformity pin their code to a specific version. After the OBBBA, some rolling-conformity states have moved to decouple from Section 174A because immediate expensing reduces state revenue. A federal return can show a full deduction for domestic research costs while the corresponding state return still requires five-year amortization.

Many states also run their own standalone R&D credits, with their own qualifying rules, rates, and carryforward periods, and some make unused credits refundable or transferable in ways the federal credit is not. The state layer should be reviewed separately rather than assumed to mirror the federal outcome.

1
Internal Revenue Service. Form 6765 – Credit for Increasing Research Activities
2
Office of the Law Revision Counsel. 26 USC 41 – Credit for Increasing Research Activities
3
Office of the Law Revision Counsel. 26 U.S. Code 41 – Credit for Increasing Research Activities
4
Internal Revenue Service. Rev. Proc. 2023-8
5
Congress.gov. H.R. 7024 – 118th Congress (2023-2024) Tax Relief for American Families and Workers Act
6
Internal Revenue Service. Rev. Proc. 2025-28
7
Internal Revenue Service. Qualified Small Business Payroll Tax Credit for Increasing Research Activities
8
Internal Revenue Service. Instructions for Form 6765 (Rev. January 2024) – Credit for Increasing Research Activities