Research and Product Development: Section 174A and the R&D Credit

Federal tax rules on research and development changed significantly for 2025 and beyond. Under Section 174A, enacted through the One Big Beautiful Bill Act, businesses can once again immediately deduct domestic research and development costs in the year they’re paid or incurred. Foreign R&D still has to be capitalized and amortized over 15 years. Separately, Section 41 offers an R&D tax credit that reduces tax dollar for dollar on a narrower set of research expenses, and for tax years beginning after 2025, the reporting form for that credit demands far more detail than before. Here’s how the deduction, the credit, and the coordination between them work in practice.

What Counts as R&D for Tax Purposes

The IRS reads research or experimental expenditures broadly. Qualifying activity involves a planned search or investigation aimed at discovering information useful in developing a new or improved product, process, formula, or invention. Two elements have to be present: genuine technical uncertainty (not just business risk) and a systematic process of experimentation to resolve it.

Costs falling within Section 174 include wages for employees performing or directly supporting the research, supplies consumed during experimentation, payments to outside contractors doing research for the business, and overhead tied to research activities such as lab rent and utilities. Section 41’s credit reaches a narrower slice: only wages, supplies, and a portion of contract research costs. Overhead is deductible but doesn’t generate any credit.

Routine work is excluded. Quality control testing of finished products, market research, management studies, and advertising don’t qualify, even when technical staff or costly equipment happen to be involved.

Deducting Domestic R&D Under Section 174A

For tax years beginning after December 31, 2024, Section 174A lets businesses immediately deduct all domestic research and experimental expenditures. This is a permanent provision and effectively restores pre-2022 treatment, before the Tax Cuts and Jobs Act imposed mandatory capitalization.

Taxpayers get a choice. The default is full expensing in the current year. As an alternative, a business can elect to capitalize domestic R&D and amortize it over no fewer than 60 months, beginning in the month the research first produces benefits. Immediate deduction reduces taxable income right away and will suit most filers, but a company with net operating losses or other timing concerns might prefer the elective capitalization.

The cash flow effect is large. During the 2022–2024 capitalization years, a company spending $1 million on domestic R&D deducted only about $100,000 in the first year. Starting in 2025, that same company deducts the full $1 million.

Amortization From 2022–2024 Continues

Domestic R&D costs incurred in tax years 2022 through 2024 were capitalized and put on a five-year amortization schedule. Those balances don’t disappear because Section 174A restored expensing. Companies keep taking the scheduled amortization deductions on current returns, reported on IRS Form 4562.¹

The move to Section 174A is treated as a change in accounting method. For the first year of the change, the IRS permitted an automatic method change using a statement with the return rather than the usual Form 3115. Method changes in later years require Form 3115.

Foreign R&D Still Amortizes Over 15 Years

Full expensing applies only to domestic research. Any research or experimental expenditures attributable to activity conducted outside the United States must be capitalized and amortized ratably over 15 years (180 months). Amortization starts at the midpoint of the tax year the expenditure is paid or incurred, so only about 3.3% of a foreign R&D cost comes off in the first year.

What counts as domestic or foreign turns on where the research physically happens, not where the company is incorporated or headquartered. A U.S. company paying researchers working in a foreign lab is incurring foreign R&D subject to the 15-year rule.

Software Development Costs

Software development is explicitly a research or experimental expenditure. IRS Notice 2023-63 confirmed the scope: any amount paid or incurred to develop computer software, whether for internal use or sale to customers, counts as an R&D cost, including coding, testing, and incidental items like documentation tied directly to the software.² Domestic software development gets full expensing under Section 174A. Software developed abroad falls under the 15-year rule.

Abandoned or Sold Research Projects

Section 174(d) bars an immediate loss deduction when a research project is abandoned, retired, or sold before amortization ends. A company that capitalized foreign R&D and kills the project two years in cannot write off the remaining balance. Amortization continues on the original schedule as if the project were still active.

For 2025-and-later domestic R&D, this rarely matters because the costs were already expensed. It still bites for foreign R&D and for unamortized balances left over from the 2022–2024 window.

The R&D Tax Credit Under Section 41

The Section 41 credit is separate from the deduction. It reduces tax owed dollar for dollar rather than reducing taxable income. To claim it, each business component (a product, process, software, technique, formula, or invention) must satisfy a four-part test.³

The research must be technological in nature, relying on principles of engineering, physics, chemistry, biology, or computer science.
It must be intended to develop a new or improved business component in function, performance, reliability, or quality. Style, taste, and cosmetic factors don’t qualify.
The capability, method, or design must be technically uncertain at the outset.
The work must involve a systematic process of experimentation evaluating alternatives to resolve that uncertainty.

Qualified research expenses (QREs) are narrower than what Section 174 deducts. Only three categories count: wages for employees performing or directly supervising qualified research, supplies consumed in the research, and 65% of amounts paid to outside contractors for qualified research.³ Overhead is out.

Two Ways to Calculate the Credit

Businesses pick between two methods, and running both is usually worth the effort.

The Regular Credit equals 20% of the amount by which current-year QREs exceed a base amount. That base is a fixed-base percentage (derived from the company’s historical ratio of research spending to gross receipts) multiplied by the average gross receipts of the four preceding tax years.³ The math gets complex for companies with long histories or uneven revenue.

The Alternative Simplified Credit equals 14% of current-year QREs exceeding 50% of the average QREs over the three prior tax years.³ A company with zero QREs in any of those three years uses a flat 6% of current-year QREs with no base subtraction. The ASC tends to work better for businesses with rapidly growing R&D spending or inconsistent research histories.

Payroll Tax Credit for Startups

Pre-revenue and early-stage companies frequently have no income tax to offset. Section 41(h) lets a qualified small business elect to apply up to $500,000 of the R&D credit per year against payroll taxes, specifically the employer’s share of Social Security tax.⁴ The cap was doubled from $250,000 by the Inflation Reduction Act for tax years beginning after 2022.

Two conditions apply. The business must have less than $5 million in gross receipts for the current tax year, and it must have had no gross receipts for any tax year preceding the five-year period ending with the current year.³ The election is made on Form 6765 and has to be filed by the return due date, including extensions.

Coordinating the Credit With the Deduction

Both benefits can’t apply in full to the same dollar of expense. Section 280C(c) requires a taxpayer who claims the R&D credit to reduce the research expenditure deduction by the amount of the credit.⁵ Claim a $100,000 credit, lose $100,000 of the deduction.

The alternative is a reduced-credit election that leaves the deduction alone. Under that election, the credit is reduced by the credit amount multiplied by the maximum corporate tax rate (currently 21%). A $100,000 credit becomes $79,000, and the full deduction stays intact.⁵ Which choice wins depends on the specific tax profile, and the reduced credit election is irrevocable for the year made, so run the numbers before filing.

Forms and the New Reporting Requirements for 2026

Section 174A deductions go on Part VI of Form 4562, the same form that captures depreciation and any remaining amortization from the 2022–2024 capitalized balances.¹

The R&D credit is claimed on Form 6765. For tax years beginning after 2025, the form’s Section G is mandatory for most filers and requires detailed business-component-level reporting of QREs.⁶ You have to report at least 80% of your total QREs broken down by individual business component, listed in descending order, capped at 50 components. Each component needs the entity’s EIN, a business activity code, the component type, and a wage breakdown by category (direct research, supervision, and support).

Two narrow exemptions from Section G exist. Qualified small businesses electing the payroll tax credit are excused. So are businesses with total controlled-group QREs of $1.5 million or less that also have average annual gross receipts of $50 million or less for the prior three years and are filing on an original return.⁶

Documentation That Holds Up in an Audit

The IRS doesn’t prescribe a rigid recordkeeping format but expects a reasonable, consistent method of tracking QREs. Companies that come through audits well maintain contemporaneous records created during the research, not reconstructed after. Courts have given little weight to records assembled after the fact.

The records that matter most include time-tracking logs distinguishing qualified research hours from routine work, project documentation showing goals, methods, iterations, and results, technical memos describing the uncertainty being resolved, and financial records tying wages, materials, and contractor costs to specific research efforts. With Section G now mandatory, businesses without project-level tracking will need to build those systems before filing their 2026 returns.

State R&D Credits Add Another Layer

Many states run their own R&D credits or deductions on top of the federal rules. Credit percentages typically range from around 5% to over 20% of qualified expenses. Some states adopt the federal four-part test; others define qualified research more narrowly. Not every state conforms to Section 174A, so some may still require capitalization of R&D costs for state purposes even though federal law allows expensing. If R&D spending is meaningful, evaluate the state benefits along with the federal ones rather than treating either in isolation.

1
Internal Revenue Service. About Form 4562, Depreciation and Amortization
2
Internal Revenue Service. IRS Notice 2023-63
3
Office of the Law Revision Counsel. 26 USC 41 – Credit for Increasing Research Activities
4
Internal Revenue Service. Qualified Small Business Payroll Tax Credit for Increasing Research Activities
5
Office of the Law Revision Counsel. 26 USC 280C – Certain Expenses for Which Credits Are Allowable
6
Internal Revenue Service. Instructions for Form 6765