The credit, and the payroll election
The federal research credit (IRC § 41) rewards spending on qualified research: work to develop a new or improved product or process that is technological in nature and involves real experimentation. For a software company that’s most of engineering, and the qualified costs are mainly the wages of the people doing or directly supervising the work, plus supplies and part of US contractor spend.
A company that loses money owes no income tax, so a credit against it would wait for years. The payroll election is what changes that. A qualified small business, under $5 million of gross receipts in the year and with no gross receipts more than five years back, can elect on Form 6765 to apply up to $500,000 a year of the credit against payroll taxes. The election is made on a timely filed original income tax return, and the credit is used on Form 8974 starting the quarter after that return is filed.
The offset comes off the employer’s share of payroll taxes: first the 6.2% Social Security tax, up to $250,000 a year, then the 1.45% Medicare tax, up to another $250,000. What a quarter’s payroll can’t absorb carries to the next quarter. A small team’s payroll is often the real limit, long before $500,000.
A worked example. A company with no research spending in any of the three prior years uses the alternative simplified credit at 6% of qualified costs. It paid $700,000 of qualified engineering wages and $100,000 to US contractors, of which 65% counts: $765,000 of qualified costs and a $45,900 credit. With $1,200,000 of annual payroll and nobody above the Social Security wage base, its employer Social Security tax is about $74,400 a year, $18,600 a quarter, so the credit is used up in the third quarter after the return is filed. Section 280C then requires either the research deduction or the credit to be reduced by the overlap, which your preparer chooses.
Section 174A: deducting research again
From 2022 through 2024, Section 174 required research and experimental costs, including all software development, to be capitalized and amortized over five years (fifteen for foreign research). For a loss-making startup that meant a tax bill on income it never had.
The 2025 tax law added Section 174A. For tax years beginning after December 31, 2024, domestic research costs can again be deducted when paid or incurred, or amortized over at least 60 months if the company elects to. Research done abroad is still amortized over 15 years, which matters if your engineers are contractors in another country.
Domestic costs capitalized in 2022 through 2024 and not yet amortized can be deducted all at once in the first tax year beginning after 2024, or spread evenly over that year and the next. Small businesses, those with average annual gross receipts of $31 million or less, could also apply the new rule retroactively and amend their 2022 to 2024 returns, but that election had to be made by July 6, 2026, and the window has closed. Either choice still open is an election your preparer should make deliberately.
- During the yearEngineering time tracked by project
- With the returnCredit and payroll election on Form 6765
- The quarter afterUp to $500,000 a year against payroll tax, on Form 8974
What to track during the year
The credit is computed from records, and the IRS can ask for them. A study done after the year closes is only as good as what was written down during it:
- Engineering time by project, in the month it happens, not reconstructed in March from memory.
- Where each person and contractor works: US research and foreign research are treated differently.
- Contractor agreements, showing who bears the risk and who keeps the rights to the work.
- Payroll registers that tie to the books, because the credit is mostly computed from wages.
On your books
Under US GAAP, research and development is generally expensed as incurred (ASC 730), with narrow exceptions for some software costs. The tax treatment above doesn’t change your income statement; it changes the tax return, and the difference between the two is tracked rather than booked twice. A payroll credit shows up as lower payroll tax in the quarters it’s applied.
Common questions
Can a startup with no profit use the R&D tax credit?
Yes, if the company is a qualified small business: under $5 million of gross receipts this year and no gross receipts more than five years ago. It can elect to apply up to $500,000 a year of the credit against payroll taxes, starting the quarter after the income tax return that claims it is filed.
Do I still have to capitalize software development under Section 174?
For tax years beginning after December 31, 2024, domestic research costs, including software development, can be deducted in the year they’re paid or incurred under Section 174A. Research done outside the US is still amortized over 15 years. Domestic costs capitalized in 2022 through 2024 that haven’t been amortized yet can be deducted in 2025 or spread over 2025 and 2026; the separate option for small businesses to amend those years closed on July 6, 2026.
Do payments to contractors count toward the R&D credit?
Generally, research performed in the US by the contractor, where your company bears the financial risk (you pay whether or not it works) and keeps substantial rights to the results. 65% of the payments count as qualified costs. Work done abroad doesn’t qualify for the credit at all, and an agreement that leaves the rights with the contractor can mean neither of you claims it.
What happens to credit we can’t use this year?
Generally, yes. Unused general business credits, the research credit among them, carry back one year and forward twenty. A company that doesn’t qualify for the payroll election, or claims more than it can use against payroll, keeps the rest for future income tax. Many states have their own research credits too.
Deciding who keeps your books? Pilot vs Lopifi: startup bookkeeping compared · Kruze vs Lopifi: startup accounting compared · Fondo vs Lopifi: startup books and tax
Terms in this guide
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Keep going
From here: the state guides that cite it.
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General information for US companies, not tax, legal or accounting advice for yours. Rules and thresholds change; confirm the specifics with a CPA before you act on them.