Before You File an R&D Credit in 2026, Check These 4 Rules - Episode 10

Section 174 vs. Section 41: The 4 “Lanes” to Plan Your 2025 R&D Tax Credit (and Section G + Payroll Election)

The episode explains that recent changes to Section 174 (deduction timing for research expenditures) are often confused with Section 41 (the R&D tax credit), causing missed tax planning and cash flow issues. It outlines four “lanes” for the 2025 filing season: (1) Section 174 deductions—domestic R&E is currently deductible again for tax years beginning after Dec. 31, 2024 (2025), while foreign research remains on slower amortization with transition complexity; (2) Section 41 credit qualification still depends on the four-part test; (3) Form 6765 Section G increases required business-component-level detail, optional in 2025 but mandatory for most in 2026 with exceptions; and (4) the payroll tax election for qualified small businesses, which can materially improve startup cash flow if timely elected. It stresses separating U.S. vs foreign work. 

Transcript

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If you're a founder or finance lead filing an RD tax credit study this year, you've probably heard of section 174 and how it's changed. I'm hearing about this a lot right now, and honestly, this is where a lot of people get confused. Most founders hear 174 and RD credit in the same sentence and assume it's all one thing. It's really not. The simplest way to think about this is that section 174 is about the deduction of research expenditures. Section 41 is about the RD tax credit. They are related, but they're not the same thing, and they're definitely not the same decision. Mixing them up is really what causes a lot of people to miss out on potential tax planning opportunities. The misunderstanding can cause cash flow issues or maybe think that their credit is disappearing when really it didn't at all. Here's the short story of it. For tax years beginning after December 31st, 2024, so think 2025, domestic RE or research and experimental expenditures is currently deductible again under section 174. Those foreign research expenditures still stay at the slower amortization track. In this video, I really want to break it down and make it feel a little bit simpler. What I'm going to do is I'm going to walk you through this using four lanes example. By the end, you should know which lane applies to you before you file, what's changed, what didn't, and what questions you should be asking your CPA before anything goes on the tax return. So let's start with the overview and kind of the map of all the four lanes. Think about the 2025 tax filing season as a conversation and these four lanes that we're going to talk about. Lane one is going to be section 174 and that deduction. That is the rule that governs how your research and development costs get written off against income. Lane two is the section 41 research and development tax credit. That is the actual RD dollar for dollar tax reduction. Those two lanes, they are connected, but they're not the same. And most confusion comes from people hearing that 174 means the credit change too. Well, look, ultimately, it didn't change. What changed was the deduction lane. Now let's talk about what happened before. Before 2022, companies generally deducted research expenditures in the year they were incurred. So think full deduction right away. Then from 2022 to 2024, taxpayers were pushed into this amortization, which means they had to be grouped and expensed over time. Now, for taxers beginning after December 31, 2024, think 2025, domestic research is deductible again under section 174, while the foreign portion still follows that aggregating and amortization over many years. There are also transition rules sitting on top of it for prior year domestic amortization, which still feels why this is really messy in real life. Here's the key point I really want people to hold on to. When someone says section 174 changed, they're talking about the deduction lane. That tells you almost nothing whether your credit qualifies. Your credit still runs through section 41 that lives and dies by the four-part test. So if you're asking whether your work qualifies or not for the credit, you still need to ask what is the permitted purpose? You know, was it technological in nature? What were the technical uncertainties? And did you have that process of experimentation? That analysis is still the backbone of the credit discussion and section 41. The deduction is really moving around and it's talking about timing, but that doesn't rewrite the qualification rules for the credit itself. Just knowing the distinction between these two lanes clears up a lot of confusion. If splitting the deduction from the credit already feels really kind of messy and difficult, that's completely normal. This is exactly where a lot of teams get stuck. So there's a link in the description below if you want to walk through your situation. But for now, let's keep going because lane three is really where the filing side starts to get a little bit of fun. Lane three, we're going to talk about the form itself, form 6765, and specifically Section G for the RD tax credit. And if you haven't looked closely at that yet, this is where the compliance conversation is going to change a lot in the coming years. The easiest way to describe Section G is that it moves a lot of the audit level thinking the IRS was doing onto the form itself. For a long time, a lot of the detailed project level support lived more in the background. You still needed it, of course, but the form itself did not force as much of that structure up front. Section G changes that dynamic by asking the business component level question information and cost bucket detail in a more direct way. So that means you need to be able to tie out wages, supplies, contract research, and other qualified research expenditures back to the business component and the activities that are being claimed. So here's the current timing on that. Section G is still optional for all tax filers for the year 2025. Starting tax year 2026, it does become mandatory for most filers. There are a few exceptions, and the IRS has laid out what those exceptions are, including the small business electing the payroll tax credit and certain taxpayers below IRS thresholds. So a very good generalist CPA may not be running this kind of business component level RD analysis that Section G is moving towards, because usually that is a specialist lane. The IRS is just requiring additional scope and depth of the RD tax credit going forward. What do you do with that? If your claim today is basically one big number and there's very little structure behind it, maybe a quick spreadsheet, maybe you have a very generic study, maybe someone handed you a number without any backup, then I would assume that you are not Section G ready. It doesn't mean that your claim is going to be denied or is dead in the water. It just means that you need to start building the RD tax credit study in the way the IRS increasingly wants to see before you file. So now is a much better time to fix it and get it done, especially as this is going to be mandatory in tax year 2026. If you realized your claim is basically one big number and nothing behind it, that's a big section G gap you could be looking at. The good news is it's usually fixable before filing. And there's a link below if you want a clear read on whether your claim is going to hold up. But let's move on to lane four because this is the one that a lot of startups miss. Lane four is going to be the payroll election. And honestly, this is the one I wish more founders planned on from day one. Normally, the section 41 RD tax credit offsets income tax, corporate income tax. That's how most people think about it. But if you are a qualified small business, you may be able to elect and use that credit against payroll taxes instead. The IRS instructions still reflect that payroll tax selection framework through the Form 6765 and its related forms. So really, why does that matter to you? Because the pre-profit startup usually has little or no income tax that they're paying on their tax return, but it is still paying payroll taxes every single month. So the payroll election is what turns the credit from a nice to have later on sort of thing into something that can matter now and can increase cash flow. This is why it matters so much to early startups. The broad pattern most founders should keep in mind is what I call the 555 rule. Under $5 million in gross receipts within the first five years of inception, and the election can only be useful across five years if you qualify. The annual cap has increased over time, and for the right startup, it can be extremely meaningful. But the practical issue that trips people up most often is not whether this concept exists, it's whether someone checks if the company qualifies and then makes the election on a timely filed return, including extensions. This is the part most people miss all of the time. And when they miss it, they don't just lose it technically. Unfortunately, they lose a cash flow planning opportunity. So if you're a startup and if you work with startups, the question is not just do we have qualified research. The question is, are we a qualified small business and are we making the payroll tax election? It's a very meaningful lever and it should happen way before the tax return is filed. So if there's one lane I plan before you file, it's this one. You can absolutely run it through your CPA, and for some companies, that's the right move. But if you'd rather have a specialist help set it up, that's where the link in the talk below is for. And you'll know pretty quickly if it fits or not. Before I get into the example, I want to touch on one issue that cuts across all four lanes because this trips people up consistently: US versus foreign work. For credit purposes, that distinction is really important. And for deduction purposes, think 174, that matters also. So if you have a hybrid team, you can't just pull all the payroll and assume it belongs in one big bucket. You need to separate it depending on the facts. And if you're in a planning state, foreign research can be painful twice over. Once because it doesn't help the credit at all. And again, because of that 174, the amortization, you get the slower write-off as well. So let's talk through with an example. Say you have 12-person US-based SaaS and AI startup. Maybe your US payroll is around $1.8 million, maybe $1.4 million of that sits in engineering, and maybe there's another $100,000 in US based contractor spend. Plus there's some offshore work that we're keeping separate. If the engineering work is qualified and supportable, we can use a rough high-level estimate just for this illustration purposes. Maybe you're looking at something like $140,000 in credit. Whether that becomes an income tax credit or a payroll tax offset election opportunity or some combination of planning around both depends on the company's fact pattern. But here's the point I really want to make. That is not a trivial number. If a company qualifies for the payroll election and handles it correctly over multiple years, the cumulative cash flow impact can get material very, very quickly. So this is why I keep saying that it's not just a tax form issue, it is really a planning issue that you need to talk with with your CPA. Not every company needs a specialist. Some claims are going to be relatively easy and some have small enough spend that a simple approach may be perfectly fine. But either way, before you file, I would ask whoever is handling the RD tax credit work these five questions. Number one, what business component are we claiming and how are we naming them? Number two, how did we determine the wage percentages, including supervision and support? Number three, how did we review contractor work, offshore work, and potentially funded work? Number four, are we Section G ready at the business component level? And number five, did we check the payroll election? Those five questions alone will tell you a lot whether the claim has been thought through or it's just been maybe randomly assembled. Okay, so here's the main takeaway. Do not treat the recent RD rules like one decision. Run your company through all four lanes: the 174 deduction, the 41 credit lane, the Section G documentation, and finally the payroll election lane. And if one of those lanes feels unclear, especially the payroll one, maybe the offshore or the documentation, that's your signal to slow down and get it reviewed before it hits the tax return. You can absolutely run this through your CPA, but if you'd rather have a specialist build it out with you, there's a link and we can talk it through. If the documentation side is a piece that you want to unpack, tell me in the comments and we can talk that through. A quick note before we wrap up this is educational purposes only. It's not individual tax advice. Every company has its own specific fact patterns and every company is different. So please check with your own tax advisor before filing. Okay, thanks for watching, and I'll see you in the next one.