The research credit: innovate, and get a tax credit for it

The numbers

Picture an S corporation manufacturer whose engineers and shop leads spend part of their time designing new parts and improving production methods. This year, the wages for that time plus supplies used in testing come to $400,000 of qualified research expenses. The average over the prior three years was $300,000.

For illustration purposes. Tax law may change, which may change these calculations slightly.

Personal tax for the owners (federal)

The $27,650 credit passes through to the owners and reduces their federal income tax dollar for dollar. Electing the reduced credit keeps the full research deduction, so you don’t have to reduce your deductions by the credit. We model both ways. Oklahoma tax is figured separately.

The credit can repeat every year you keep doing qualified research. Businesses that haven’t claimed it can often go back and claim it on amended returns for open years.

How it works

1. Identify qualified projects. Each project, or “business component,” must pass a four-part test: it aims to create or improve a product, process, software, technique, formula, or invention; it relies on engineering, physical or biological science, or computer science; it starts with real uncertainty about how to do it or what the design should be; and you work through it by testing alternatives.
2. Add up qualified costs. Wages for people doing, directly supervising, or directly supporting the research; supplies used up in it; certain cloud computing costs; and 65% of what you pay U.S. contractors to do research for you.
3. Figure the credit. Most businesses use the alternative simplified method: 14% of costs above half of the prior three-year average (6% if you had no research costs in any of the prior three years).
4. Deduct the costs. Under Section 174A, domestic research costs are deductible in the year paid for tax years beginning after 2024. Foreign research is still spread over 15 years.
5. Use the credit. It reduces income tax. Qualified small businesses (under $5 million of gross receipts and within their first five years of receipts) can apply up to $500,000 a year against the employer share of payroll tax instead.

Who it fits

• Manufacturers and fabricators designing new parts, tooling, or production methods.
• Contractors doing design-build, engineering, or new building methods, when they bear the risk of the design.
• Software companies and businesses building their own software to solve technical problems.
• Food, agriculture, and energy businesses developing new formulas, processes, or techniques.

What doesn’t qualify

• Routine testing, quality control, or work after commercial production begins.
• Research funded by a customer, when you don’t bear the risk or keep rights to the results.
• Adapting an existing product for one customer, market research, or social science research.

The rules

• Documentation. Keep records that tie people, time, and costs to each project, made as the work happens. Form 6765 now asks for more detail on each business component.
• No double benefit. The credit and the research deduction interact. You either reduce the deduction by the credit or elect a reduced credit; we choose the better result.
• Costs from 2022–2024. Domestic research costs that had to be capitalized in 2022–2024 can generally be deducted faster now. Options depend on your business size; we check what applies to you.
• Credit limits. The credit is a general business credit with annual limits. Unused credit generally carries back one year and forward 20 years.

Risks and costs to weigh

• IRS scrutiny. The research credit is a common audit topic. Claims built on estimates instead of records are the ones that fail.
• Overreach. Calling every project “research” invites trouble. We claim what the facts support.
• Study costs. A credit study takes time from your team. For small claims, the paperwork can outweigh the credit.

How we handle it for clients

With a Cannon & Brown tax plan, we find the projects that qualify, set up simple time and cost tracking during the year, and figure the credit and the Section 174A deduction together so you get the better result. Because our technology keeps your books and payroll current all year, the records that support the credit are built as the work happens, not reconstructed after year end. Your tax strategist reviews every recommendation.

Illustrative example. The business and figures on this page are hypothetical, used to explain how the strategy works. They are not a client and not a promise of results. The example assumes an S corporation using the alternative simplified credit, $400,000 of qualified research expenses, a $300,000 prior three-year average, and the reduced-credit election at the 21% rate. This page is educational and is not tax or legal advice for your situation; tax rules and limits change.