Research and development tax credit

The research credit (Internal Revenue Code section 41) rewards businesses for increasing their spending on qualified research, such as wages for staff doing the work, supplies used in it, and part of what you pay contractors to do it for you. It is a credit, so it reduces the tax you owe dollar for dollar.

What counts: the IRS applies a "four-part test" to each product, process or piece of software you work on. The work must be treated as research and experimental spending for tax purposes, aim to discover information that is technological in nature, be meant to create a new or improved business component, and consist substantially of a process of experimentation about its function, performance, reliability or quality.

How much: the regular credit is 20% of qualified research spending above a base amount. Many businesses choose the simpler alternative: 14% of this year's qualified spending above half the average of the last three years. You claim it on Form 6765 with your tax return. From tax years beginning after 2025, the form's business component section (Section G) is required for most filers.

Using it against payroll tax: a qualified small business can elect to apply up to $500,000 of the credit each year against the employer's share of social security tax, and then Medicare tax. A qualified small business is a corporation (including an S corporation) or partnership with gross receipts under $5 million for the year and no gross receipts in any year before the last five. You make the election on Form 6765 with a return filed on time (including extensions), not on an amended return, and you can make it for no more than five years. The credit then applies on your payroll tax returns (Form 8974 with Form 941) from the first quarter that starts after you file. Tax-exempt organizations cannot use it.

Deducting research costs: since the 2025 budget law (Public Law 119-21), businesses can deduct domestic research and experimental spending in tax years beginning after December 31, 2024 (section 174A), or choose to spread it over at least 60 months. A one-time option for businesses with average yearly receipts of $31 million or less to apply this to their 2022 to 2024 returns had to be made by July 6, 2026. Claiming the credit means either reducing that deduction by the credit or electing a smaller credit.