R&D Expenses: Section 174 Deduction and Section 41 Credit

Under IRS rules for R&D expenses, domestic research and experimental costs are once again immediately deductible for tax years beginning after December 31, 2024, under new Section 174A of the Internal Revenue Code. Foreign R&D costs still have to be capitalized and amortized over 15 years. A separate research credit under Section 41 can reduce your tax bill directly, on top of the deduction, if your activities pass a stricter four-part test. The change to Section 174A, enacted in 2025 under the One Big Beautiful Bill Act (OBBBA), is permanent and reverses the five-year capitalization requirement that applied from 2022 through 2024.

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.¹ Whether the project ultimately succeeds doesn’t matter. Costs incurred before you resolve that uncertainty count, even if some production has already started.

Software development is explicitly included. Any amount paid or incurred to develop or improve computer software is treated as a research or experimental expenditure.² That covers coding, software engineering, architecture and user interface design, quality assurance tied to development, deployment, and cloud hosting for the development environment. Routine activities like configuring off-the-shelf software, ongoing maintenance, and customer support generally don’t qualify.

Several categories of spending are excluded outright, no matter how experimental they feel:

Market research, consumer surveys, advertising, and sales promotions.
Quality control testing, efficiency surveys, and management studies.
Purchases of someone else’s patent, model, or production process.
Land and depreciable property, including buildings and equipment that get their own depreciation deductions.
Mineral exploration spending to locate or evaluate ore, oil, gas, or other deposits.

These exclusions apply even when the spending happens alongside legitimate research work.¹

Which Costs You Allocate to R&D

When employees and resources split time between research and other work, you have to allocate costs based on a cause-and-effect relationship. IRS Notice 2023-63 lays out the categories that must be allocated to research activities.³

Labor: compensation 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.
Attorney fees for preparing and filing patent applications.
Facility overhead: rent, utilities, insurance, repairs, and security for spaces and equipment used in R&D.
Travel costs directly tied to performing research.

Costs from general administrative departments that only indirectly benefit R&D are not allocated. Interest on debt used to finance research is also excluded, along with website hosting fees, domain registration, and costs for inputting content into a website.³ The line between “directly supports” and “indirectly benefits” R&D is where most disputes arise, so contemporaneous time-tracking matters.

Immediate Deduction for Domestic R&D

For tax years beginning after December 31, 2024, Section 174A lets you deduct qualifying domestic R&D in the year you pay or incur it.⁴ No capitalization, no amortization schedule. The provision is permanent.

One alternative exists. You can elect to capitalize domestic R&D and amortize it over a period of no less than 60 months, beginning in the month you first realize benefits from the research. This election generally only helps in narrow situations, such as when a business with net operating losses wants to preserve deductions for a future profitable year.

Foreign R&D Still Amortizes Over 15 Years

R&D attributable to research performed outside the United States cannot be immediately deducted. Those costs must be capitalized and amortized ratably over 15 years, starting at the midpoint of the tax year in which you pay or incur the expense.² The midpoint convention means only a half-year of amortization in year one.

Selling, retiring, or abandoning property connected to foreign R&D does not accelerate the remaining deduction. The unamortized balance stays on its original schedule, and you cannot reduce your amount realized on a disposition by the unamortized costs.² Walking away from a failed overseas project doesn’t accelerate any tax relief.

Recovering R&D Costs Capitalized During 2022–2024

From 2022 through 2024, all domestic R&D had to be capitalized over five years under the original TCJA rules.⁵ The OBBBA gives you two ways to clear any remaining unamortized balance from those years: take the full remaining amount as a deduction 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 filer, that means deducting the full balance on your 2025 return or splitting it between 2025 and 2026.

Small businesses get one more option. If your average annual gross receipts are $31 million or less under the Section 448(c) test, you can elect to apply Section 174A retroactively to 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 can’t file retroactive amended returns and have to use the prospective transition rules.

The Section 41 R&D Tax Credit

The credit is a separate benefit from the deduction. Where the deduction reduces taxable income, the Section 41 credit reduces tax owed dollar-for-dollar. You can claim both, subject to the coordination rules covered further down.

The Four-Part Test

Activities must pass all four parts of a test that is more demanding than the Section 174 definition:

New or improved business component. The research must aim to improve the function, performance, reliability, or quality of a product, process, software, technique, or formula. Research related only to style, taste, or cosmetic factors does not qualify.⁶
Technical uncertainty. You must be trying to discover information that resolves uncertainty about capability, method, or appropriate design.
Process of experimentation. Substantially all of the activity must involve systematic evaluation of alternatives through modeling, simulation, testing, or similar methods.
Technological in nature. The work must rely on principles of physical science, biological science, engineering, or computer science.

Each business component is evaluated on its own, so one qualifying project can generate credits even if others at the same company wouldn’t.

Qualified Research Expenses

Only specific costs count as qualified research expenses (QREs). In-house QREs include wages for employees who directly perform or supervise qualified research, plus supplies consumed in the research. A supply here means tangible, non-depreciable property used directly in the research.

Contract research expenses are limited to 65% of amounts paid to outside parties for qualified research.⁶ The research must be performed on your behalf, and you must bear the economic risk of failure. Work that wouldn’t have qualified in-house doesn’t become qualified because you hired it out.

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 future years unless the IRS consents to a change.

Payroll Tax Offset for Startups

Startups without an income tax liability can still use the credit. A qualified small business can elect to apply up to $500,000 of the credit per year against its share of employer payroll taxes.⁷ The Inflation Reduction Act raised this cap from $250,000 for tax years after 2022. Up to $250,000 per quarter applies against the employer share of Social Security tax, with any excess going against the employer Medicare share. Unused amounts carry forward to the next quarter.

To qualify, your gross receipts for the current year must be under $5 million, and you cannot have had any gross receipts in any tax year before the five-year period ending with the current year.⁸ The offset is effectively available only in the first five years of existence.

Coordinating the Deduction and the Credit

You cannot claim a full deduction and a full credit on the same spending. Section 280C reduces your otherwise allowable deduction for domestic R&D 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 this election, the credit is reduced by the product of the credit and the maximum corporate rate (currently 21%). A $50,000 credit becomes $39,500, and the $1 million deduction stays intact. Running both scenarios each year determines which produces the better result. The election is made on your return and is irrevocable for that year.⁹

Filing, Documentation, and Penalties

Forms

The credit is claimed on Form 6765, Credit for Increasing Research Activities, attached to your income tax return. For tax years beginning after 2025, Section G of Form 6765 is mandatory for most filers. It requires detailed business component reporting, listing at least 80% of total QREs by component (up to 50 components) in descending order.⁴ Two narrow exceptions apply: qualified small businesses claiming the payroll 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 accounting methods for R&D, including switching from the 2022–2024 capitalization method to Section 174A expensing, file Form 3115, Application for Change in Accounting Method.⁵ Automatic consent procedures apply for Section 174 changes, so individual IRS approval generally isn’t required. Ongoing amortization of foreign R&D is reported on Part VI of Form 4562.

Documentation

Records must connect each claimed expense to a specific qualifying activity. For the credit, keep project narratives explaining the technical uncertainty, contemporaneous time-tracking for wages included in QREs, and written contracts with invoices and payment proof for third-party research. For the deduction, keep records showing how you allocated employees and overhead between research and other operations. The cause-and-effect standard in Notice 2023-63 is what auditors apply.³

Penalties

Improperly expensing costs that should be capitalized, or overclaiming the credit, can trigger accuracy-related penalties of 20% of the underpayment attributable to negligence or disregard of rules. The same 20% rate applies for a substantial understatement of tax, 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 primary defense against both the penalty and the underlying adjustment.

State Tax Treatment May Differ

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

1
eCFR. 26 CFR 1.174-2 – Definition of Research and Experimental Expenditures
2
Office of the Law Revision Counsel. 26 U.S. Code 174 – Amortization of Research and Experimental Expenditures
3
Internal Revenue Service. Notice 2023-63 – Specified Research or Experimental Expenditures
4
Internal Revenue Service. Instructions for Form 6765 (Rev. December 2025)
5
Internal Revenue Service. Revenue Procedure 2023-8 – Procedures for Changing Methods of Accounting for 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