The R&D tax credit for Palo Alto startups

Most Palo Alto startups spend the bulk of their early money on engineers. Much of that spending can count toward the federal credit for increasing research activities, usually called the R&D credit. For a profitable company the credit cuts income tax. For a young company that has no income tax to cut, a special election turns part of the credit into a reduction of payroll taxes. That second route is why so many seed-stage founders hear about the credit from their accountants in the first year or two.

This guide covers the federal credit, the payroll tax election, the 2025 change to how research costs are deducted under Section 174 and the separate California credit. If you have not set up your company yet, start with our guide to incorporating a startup. If you also chase grant money, read our page on SBIR and government grants, since grant-funded research can affect what you claim.

What counts as qualified research

The IRS instructions for Form 6765 describe a "four-part test" that each project, called a business component, must pass:

1. The costs must be domestic research or experimental expenditures under Section 174A.
2. The work must aim to discover information that is technological in nature.
3. The information must be meant for developing a new or improved product, process, software, technique, formula or invention.
4. Substantially all of the activities must be part of a process of experimentation about function, performance, reliability or quality.

Software, hardware, chemistry and biology work often fits. Market research, routine quality testing, cosmetic design changes and work after commercial production starts generally do not. The test is applied project by project, not to the company as a whole.

Qualified research expenses

The credit is figured on qualified research expenses, or QREs. They fall into a few buckets:

• Wages for employees who do, directly supervise or directly support qualified research. For most software startups this is the largest piece.
• Supplies used up in the research, such as materials for prototypes.
• Contract research. The IRS counts 65 percent of amounts paid to outside parties for qualified research done on your behalf. For payments to a qualified research consortium the share is 75 percent.

Equity grants, rent and general overhead are not QREs. Research paid for by someone else, such as a customer or many grant agreements, may not count either. That point matters for companies with SBIR awards.

How the federal credit is figured

Form 6765 offers two methods. Most startups use the second.

A company in its first research year often has no prior QREs, so the 6 percent rate applies. The ASC must be elected on a timely filed original return, including extensions. The IRS will not grant extra time to make it.

The Section 280C election at the top of the form trades a smaller credit for not having to reduce your research deduction by the credit amount. Your preparer will model both.

The payroll tax offset for young companies

A company that loses money pays no income tax, so an income tax credit would sit unused for years. Congress addressed that for small companies. Under the IRS instructions, a qualified small business can elect to apply part of its research credit against payroll taxes instead.

Who qualifies

The IRS defines a qualified small business for this election as a corporation or partnership with:

• gross receipts of less than $5 million for the tax year;
• no gross receipts for any tax year before the five-year period ending with that tax year.

In plain terms, the company must be young and small. A company that earned its first revenue six years ago no longer qualifies, even if revenue is still low.

How much and how it is used

The election was capped at $250,000 a year for tax years beginning before 2023. The Inflation Reduction Act raised it to $500,000 for tax years beginning after December 31, 2022, according to the Form 8974 instructions. The steps:

1. Figure the credit and make the payroll election on Form 6765 with your timely filed income tax return.
2. Attach Form 8974 to your quarterly Form 941 for the first quarter that begins after you file that return.
3. The credit first reduces the employer share of Social Security tax, up to $250,000 a quarter. Anything left reduces the employer share of Medicare tax.
4. Credit that still remains carries forward to the next quarter.

Timing matters. A calendar-year startup that files its return in March claims the offset starting in the second quarter. Filing on extension in October pushes the benefit to the first quarter of the next year. Payroll providers can usually add Form 8974 to the quarterly filing if you tell them in advance. Our guide to payroll and benefits covers the rest of the payroll setup.

Section 174 in 2026

Section 174 is not a credit. It decides when research costs can be deducted. It caused years of pain for startups and changed again in 2025.

• 2022 to 2024. Under the 2017 tax law, research costs paid in tax years beginning after 2021 had to be capitalized and amortized: over five years for domestic research and 15 years for foreign research. Many money-losing startups found themselves with taxable income.
• From 2025. P.L. 119-21, commonly called the One Big Beautiful Bill Act, added Section 174A. The IRS says it lets taxpayers deduct domestic research costs paid or incurred in tax years beginning after December 31, 2024. A company can instead elect to amortize them over at least 60 months.
• Foreign research. Costs for research done outside the United States are still amortized over 15 years.
• Leftover amounts from 2022 to 2024. Rev. Proc. 2025-28 explains that a company may deduct remaining unamortized domestic amounts in full in its first tax year beginning after 2024 or spread them over two years.

The small business look-back has closed

The law also let small business taxpayers apply the new rule back to 2022. Rev. Proc. 2025-28 defines them by the gross receipts test of Section 448(c), $31 million for tax years beginning in 2025. That election generally required amended returns and had to be made by July 6, 2026. If you missed it, ask your preparer which other method changes are still open to you.

The California research credit

California has its own credit for research done in the state. The Franchise Tax Board says it is based on the federal credit with modifications:

• Regular method: 15 percent of qualified expenses above a base amount, plus 24 percent of basic research payments.
• Alternative simplified credit: California conformed to the federal ASC method as of January 1, 2025. The state version is 3 percent of QREs above half the average of the prior three years, or 1.3 percent of current QREs if a prior year had none.
• Alternative incremental credit: repealed for tax years beginning after January 1, 2025.
• Carryover: unused credit carries over until it is used up.
• Form: claimed on FTB 3523 with the return.

The FTB's page lists no payroll tax version. For a company with no California income, the credit simply builds up for later years. Research done in Texas or overseas does not count toward the California credit.

The $5 million limit through 2026

The 2025 FTB 3523 instructions describe a temporary cap. For tax years beginning on or after January 1, 2024 and before January 1, 2027, all business credits together may not reduce tax by more than $5 million. Companies can make an irrevocable election to turn disallowed credits into a refundable credit paid out over five years, starting in the third year after the election. Few seed-stage companies come near the cap, but later-stage companies should plan for it.

Records that hold up

The IRS has asked for more detail in recent years. For tax years beginning after 2025, Section G of Form 6765, which reports QREs by business component, is required for most filers. Amended-return refund claims must also include specific information to be valid. Good habits from day one make all of this easier:

• Track time by project, even roughly, in your issue tracker or a simple spreadsheet.
• Keep design documents, experiment logs and failed approaches. Failure is evidence of experimentation.
• Separate research contractors from marketing and operations vendors in your books.
• Note which work is funded by grants or customer contracts.
• Store the payroll reports that support wage QREs.

Getting help

Founders usually claim the credit through their tax preparer or a firm that runs research credit studies. Fees vary. Some firms charge a percentage of the credit, others a flat fee. Ask how the firm documents projects and whether it will support you in an exam. Our guide to accounting firms near Palo Alto lists firms with local offices. The IRS also publishes advice on choosing a tax professional.

The credit also interacts with your equity story. Investors read the tax footnotes in your financial statements. A large carryforward can also matter in an acquisition. Our pages on equity and stock options and term sheet basics cover the financing side.

Frequently asked questions