For tax years beginning in 2022 through 2024, businesses were required to capitalize research and experimental costs and recover domestic costs over five years under IRC §174. For manufacturers that design products or improve processes, that pushed deductions years into the future. The 2025 federal tax law changed course.
What changed
Public Law 119-21, enacted July 4, 2025, added a new IRC §174A. The key points:
- Immediate deduction. For tax years beginning after December 31, 2024, domestic research or experimental expenditures may be deducted in the year they are paid or incurred (IRC §174A(a)).
- Optional amortization. A business may instead elect to capitalize these costs and amortize them over at least 60 months, beginning with the month it first realizes benefits from the work (IRC §174A(c)).
- Software counts. Costs paid or incurred to develop software are treated as research or experimental expenditures (IRC §174A(b)), which can matter for manufacturers that write product or control software.
- Foreign research is unchanged. Research performed outside the United States continues to be amortized over 15 years under IRC §174 (Rev. Proc. 2025-28).
- Equipment and land are separate. Costs to acquire or improve land, or to acquire depreciable property such as a new machine, are not deducted under §174A (IRC §174A(d)). They are recovered under their own rules.
What about costs from 2022 through 2024?
The law included transition rules for domestic costs capitalized in those years (P.L. 119-21, §70302(f); Rev. Proc. 2025-28).
The small business retroactive election. Businesses that met the gross receipts test of IRC §448(c) for their first tax year beginning after 2024 ($31 million for tax years beginning in 2025) and were not tax shelters could elect to apply the new rules back to tax years beginning after December 31, 2021, generally through amended returns or administrative adjustment requests. That election was due on or before July 6, 2026, or earlier for some 2022 tax years, so for most businesses this window has now closed.
Remaining unamortized balances. Any business with unamortized domestic costs from those years could elect to deduct the remaining balance in full in its first tax year beginning after December 31, 2024, or ratably over that year and the next. For calendar-year businesses, that first year was 2025, so the choice generally belonged on the 2025 return. If your 2025 return is already filed, it may be worth confirming which approach was used, since a two-year choice also affects your 2026 return. Fiscal-year businesses may still have that first return ahead of them.
What counts as research for a manufacturer
Treasury regulations have long described research or experimental expenditures as costs incident to developing or improving a product, in the experimental or laboratory sense, when the information available does not yet establish the capability or method for developing it, or its appropriate design (Treas. Reg. §1.174-2(a)(1)). “Product” is defined broadly to include a pilot model, process, formula, invention, technique, patent, or similar property.
For manufacturers, activities that may fit include:
- Designing a new product or component when the design is not yet settled
- Developing or improving a manufacturing process, formula, or technique
- Building and testing prototypes and pilot models
- Developing software used in products or production
The same regulation excludes ordinary quality control testing, efficiency surveys, management studies, consumer surveys, advertising, and buying another party’s patent, model, or process (Treas. Reg. §1.174-2(a)(6)). Testing to determine whether a design is appropriate is not treated as quality control testing (Treas. Reg. §1.174-2(a)(7)).
How it fits with the research credit
The §174A deduction and the research credit under IRC §41 are related but separate. The credit applies to qualified research, which starts with expenditures treated as domestic research or experimental expenditures under §174A and adds further tests (IRC §41(d)):
- The research seeks to discover information that is technological in nature.
- The information is intended to be useful in developing a new or improved business component.
- Substantially all of the activities are part of a process of experimentation.
Certain activities are excluded, including research after commercial production begins, adapting or duplicating an existing business component, and funded research (IRC §41(d)(4)).
Coordinating the two. Under IRC §280C(c), the §174A deduction is reduced by the amount of the research credit, unless the business elects a reduced credit instead. That election is made on a timely filed original return, including extensions, and cannot be revoked once made. Modeling both approaches before filing can help show which one fits.
The payroll tax election. A qualified small business, generally one with gross receipts under $5 million for the year and no gross receipts in any year before the five-year period ending with that year, may elect to apply up to $500,000 of its research credit against payroll taxes (IRC §41(h)). The credit first reduces the employer share of Social Security tax, up to $250,000 per quarter, and any remainder reduces the employer share of Medicare tax. The election is made on Form 6765 by the due date of the originally filed return, including extensions, and the credit is claimed on Form 8974 beginning with the first calendar quarter that starts after that return is filed (IRS, Research credit against payroll tax for small businesses). For a newer manufacturer that is not yet profitable, this may turn a credit into usable cash sooner.
Documentation
Strong records support both the deduction and the credit:
- Project files that describe the goal, the technical uncertainty, the alternatives tried, and the results
- Time records that tie employee hours to specific projects
- Separate accounts or classes in your books for research costs, with domestic and foreign work kept apart
- Contracts with outside developers or labs, which help show where research was performed and who bears the risk
Under the Form 6765 instructions, Section G, which reports information by business component, is required for tax years beginning after 2025 unless an exception applies. Building that detail into your records now may make next year’s return easier to prepare.
Finally, California does not automatically follow federal changes and has its own research credit, so state treatment may differ.
How TreeStar can help
TreeStar reviews research activity with manufacturers during the year, helps keep domestic and foreign costs separate in the books, and models how the deduction and the research credit work together on both the business and owner returns. Our tax planning service is built for decisions like these.
This article is general information, not advice for your situation. Rules change; confirm current law before acting.
