R&D Credit Under Section 174A: Why a Startup Should Take the Full $109,200 Against Payroll

Two rules decide what research is worth to a small software company in 2026. Under the new section 174A, domestic research costs are deducted in full in the year they are paid. And a company with less than $5 million of gross receipts can apply its research credit to its payroll tax bill, so the credit pays cash even in a year with no income tax to offset.

The question we get on calls is whether to also check the box for the reduced credit on Form 6765. For a C corporation that is losing money, we say no. In the example below, on $1,130,000 of qualified research, the box turns a $109,200 payroll credit into $86,268.

1. What changed for 2026

From 2022 through 2024, every dollar of research spending had to be capitalized. Domestic costs were amortized over 5 years and foreign costs over 15, both starting at the midpoint of the year, so a company deducted 10% of a year's spending in that year. Software development counted as research spending, whatever its purpose.

Public Law 119-21, signed July 4, 2025, added section 174A. For amounts paid or incurred in tax years beginning after December 31, 2024, domestic research and experimental expenditures are deducted in full in the year paid or incurred. Software development still counts. A company can instead elect to amortize over 60 months or more, which makes sense for a company that needs taxable income to use up a loss or credit before it expires.

Foreign research did not get relief. Under the amended section 174, it is still amortized over 15 years from the midpoint of the year. A contractor team overseas costs the same cash as before and still gives you only a sliver of a deduction in year one.

2. The four tests research has to pass

The deduction and the credit cover different sets of costs. Section 174A covers research and experimental expenditures broadly. The credit in section 41 covers only qualified research, and section 41(d)(1) sets four tests for it:

• Section 174A costs. The spending has to be treated as domestic research or experimental expenditures under section 174A.
• Technological information. The work has to aim at discovering information that is technological in nature, which means it rests on computer science, engineering or the physical or biological sciences.
• A business component. That information has to be meant for developing a new or improved product, process, software, technique, formula or invention, judged by its function, performance, reliability or quality. Style and cosmetic changes do not count.
• A process of experimentation. Substantially all of the activity has to involve evaluating alternatives to resolve an uncertainty about capability, method or design.

Section 41(d)(4) then excludes work done after commercial production begins, adapting or copying an existing product, surveys and routine testing, research funded by a customer or grant, research done outside the United States, and most software built for internal use. For a company selling software to customers, the internal-use rule rarely bites. Bug fixes after release and customer-specific configuration often do.

3. What counts as a qualified research expense

Qualified research expenses are wages for people doing, directly supervising or directly supporting the research, supplies used in it, and amounts paid to rent computers for it. A contractor's invoice counts at 65%, under section 41(b)(3), when the company pays whether or not the research succeeds and has a right to the results. Rent, untaxed benefits such as health insurance and 401(k) contributions, recruiting and most overhead stay out, even though some of them are research expenditures under section 174A.

The credit itself, for most small companies, is the alternative simplified credit: 14% of the amount by which this year's qualified research expenses exceed half the average of the prior three years. A company with no qualified research expenses in any one of those three years uses 6% of the current year instead. The prior three years have to be measured on the same definition as the current year, so a company that never ran a credit study may need to rebuild them from payroll and project records.

4. A $3.2 million software company, line by line

A C corporation sells software to customers. It first had gross receipts in 2023, has $3,200,000 of revenue in 2026, and spends $3,600,000. Of that, $1,400,000 is domestic research spending: $1,100,000 of developer wages, $200,000 paid to a US contractor and $100,000 of hosting and tools. $1,000,000 of the developer wages is for work that passes the four tests. We leave the hosting and tools out of the credit to keep the example conservative. Cloud servers rented for development and testing can count as computer rental, but only if someone else owns and runs them off your premises and you are not their primary user. Qualified research expenses were $500,000 in 2023, $700,000 in 2024 and $900,000 in 2025.

Under the 2022 to 2024 rules, the same $1,400,000 would have produced a $140,000 deduction this year. On this year's spending alone, before amortization carried in from earlier years, the company would have reported $860,000 of taxable income and owed $180,600 at the 21% corporate rate before any credit.

5. Taking the credit against payroll tax

A loss-making company cannot use an income tax credit. Section 41(h) lets a qualified small business elect to apply up to $500,000 a year of the credit against its payroll taxes instead. A C corporation can move to payroll only the part of the credit it cannot use against that year's income tax, which in the example is all of it because the company has a loss. A company qualifies for a year if gross receipts for that year, counted across its controlled group and including interest income, are under $5,000,000 and it had no gross receipts in any year before the 5-year period ending with that year. The example company, with first receipts in 2023, qualifies for 2026. The election is available for at most five years, and an S corporation or partnership makes it at the entity level.

The election goes on Form 6765, Section D, filed with a timely return, extensions included. The Form 8974 instructions say the first $250,000 goes against the employer's Social Security tax and anything beyond it against the employer's Medicare tax, starting with the quarter that begins after the income tax return is filed. Form 8974 goes with Form 941 each quarter, and any credit left over rolls to the next quarter.

Suppose the company files its 2026 return in March 2027 and pays $1,600,000 of wages a year, all under the Social Security wage base. Its employer Social Security tax is $99,200 a year, or $24,800 a quarter. If payroll holds at that level, the $109,200 runs from the quarter starting April 1, 2027 through the second quarter of 2028: four quarters of $24,800 and a fifth of $10,000.

6. Why we skip the reduced-credit election here

Under section 280C(c), a company that claims the credit must reduce its section 174A deduction by the credit. It can instead elect a reduced credit, cut by the top corporate rate of 21%, and keep the full deduction. The box is Item A on Form 6765. It must be checked on a timely original return and cannot be changed later.

For a C corporation paying tax at 21% this year, the two routes come out the same. For one with a loss, they do not. Without the election, the company gets $109,200 against payroll starting next spring, and its net operating loss is $109,200 smaller. With it, the company gets $86,268, so the election gives up $22,932 of cash now. A loss of $109,200 is worth at most the same $22,932 later, and under section 172 a carried-forward loss can offset only 80% of a later year's taxable income.

The answer can flip for owners of an S corporation or partnership in a high bracket. The 280C cut is set at 21% no matter what rate the owner pays. Take a separate case where the same $109,200 credit flows to a 37% owner. Skipping the election costs that owner $40,404 of deduction value, while electing costs $22,932, so electing is $17,472 better. That assumes the owner can use the deduction this year. In a loss year like the example's, basis, at-risk, passive activity and excess business loss limits can push that value to a later year. We run the owner's return both ways before checking the box.

7. The 2022 to 2024 costs still on your books

Rev. Proc. 2025-28 set out two ways to recover costs capitalized from 2022 through 2024. A company meeting the section 448(c) gross receipts test for its first tax year beginning after 2024 ($31,000,000 for a year beginning in 2025) could apply section 174A back to 2022, generally by amending returns. That window closed on Monday, July 6, 2026, or earlier for a 2022 return whose refund deadline came first.

Any company could instead deduct the remaining unamortized amount in full on its 2025 return, or spread it ratably over 2025 and 2026. That choice was made on the 2025 return. If you chose the spread, the second half belongs on your 2026 return. If you made neither choice, the old 5-year schedule keeps running. Check which one your 2025 return used before anyone builds the 2026 numbers.

8. What Form 6765 asks for in 2026

Section G of Form 6765 was optional for tax years beginning before 2026. For 2026 it is required, with two exceptions. A qualified small business that checks the payroll election box is exempt. So is a company whose qualified research expenses, measured across its controlled group, are $1.5 million or less, whose average gross receipts for the prior three years are $50 million or less, and which claims the credit on an original return. The example company passes both.

Everyone else lists business components covering at least 80% of qualified research expenses, up to 50 components, largest first. Each line carries the component's name, its type (product, process or other), the software category where it applies, and wages split among direct research, direct supervision and direct support, plus supplies and computer rental. Claims on an amended return also need column 49(f), the information the research set out to discover.

A company that is exempt from Section G still needs the same records to defend the credit. We build the component list from the time tracking and the ticket history during the year, because reconstructing it at filing time is where credits get cut.

9. What to do before filing the 2026 return

• Split domestic from foreign. Tag each contractor and payroll line by where the research was done, because foreign costs stay on 15-year amortization.
• Tie wages to components. Record each developer's time against named projects, and mark the hours spent on new functionality versus maintenance and support.
• Test the $5 million line. Confirm this year's gross receipts and the year of your first receipts before counting on the payroll election.
• Decide on Item A with numbers. Compare the reduced credit against the 280C add-back at your actual rate, and remember the choice is final once the return is filed.
• Find your 2025 transition choice. Pull the 2025 return and see whether a second-year deduction of 2022 to 2024 costs belongs on the 2026 return.
• File on time. The payroll election and the reduced-credit election are both lost on a late return.

Our tax planning work runs the whole chain: classifying the research spend in the books, computing the credit, making the payroll election and filing Form 8974 with each quarter's 941. Book a call with your 2025 return, a payroll register by employee and a list of what the engineering team shipped this year. If the credit is too small to justify the documentation, we will say so before you spend the time.

General information for owner-operators, not tax advice. Thresholds change and state treatment varies; confirm current requirements for your own facts before acting.