If your engineers spent last year figuring out how to build something that didn't exist yet, you may have been doing research and development in the eyes of the tax code, without a lab coat in sight. Many startups qualify for the federal research credit, and early-stage companies can sometimes turn it into payroll tax savings before they ever turn a profit.
What qualifies
Activities generally qualify if they meet four tests:
- A permitted purpose. You're creating or improving a product, process, software, or formula.
- Technological in nature. The work relies on engineering, computer science, or the physical or biological sciences.
- Uncertainty. At the start, you didn't know how to achieve the result, or the best way to get there.
- Experimentation. You worked through that uncertainty by testing, modeling, or trying different approaches.
Routine work usually doesn't qualify. Examples include cosmetic changes, routine data collection, and work done after a product is in commercial production.
What costs count
- Wages for employees doing, directly supervising, or directly supporting qualifying work
- Supplies used up in the research
- A portion of payments to contractors who perform qualifying research for you, generally 65%
- Certain cloud computing costs used for development and testing
The payroll tax option for startups
A credit against income tax doesn't help much if you aren't profitable yet. Qualified small businesses can instead apply up to $500,000 of the credit each year against payroll taxes: up to $250,000 against the employer's share of Social Security tax and up to $250,000 against the employer's share of Medicare tax.
To qualify, a business generally needs gross receipts under $5 million for the year and no gross receipts in any year before the most recent five. The election is available for up to five years.
The election is made on Form 6765 with a timely filed income tax return. The credit then reduces payroll taxes starting in the quarter after that return is filed, claimed with Form 8974 alongside your quarterly Form 941.
How it fits with R&D deductions
The 2025 tax law restored immediate deductions for domestic research and development costs, which had required spreading over five years since 2022. The credit and the deduction work together, so both should be considered when planning.
Documentation is everything
The IRS now asks for more detail about research projects than it used to. The strongest claims are built on records kept during the year: project descriptions, the technical problems being solved, who worked on them, and how their time was spent. Reconstructing all of this after year-end is harder and less convincing.
Don't forget your state
Many states offer their own research credits. California has one, with its own rules, and it doesn't offer the payroll tax option.
We'd start documenting in January, not at tax time. A short monthly note on what the team built and why it was hard is worth more than any spreadsheet pieced together a year later.