Manufacturers run process improvements, prototype builds, and tooling trials every year, and many of those projects fund a federal tax benefit they never claim. The R&D credit manufacturing opportunity sits inside two related sections of the tax code: IRC Section 41, which creates the credit, and IRC Section 174, which governs how research costs are deducted or capitalized. The rules under Section 174 changed materially in 2025, so any manufacturer working from old guidance is now working from the wrong playbook.
Quick answer: Manufacturers can claim the federal research credit under IRC Section 41 for qualifying activities such as developing new products, improving production processes, designing tooling, and testing materials, provided the work passes the four-part test. Separately, under Section 174A enacted by the One Big Beautiful Bill Act, domestic research expenditures are again fully deductible in the year paid or incurred for tax years beginning after December 31, 2024, reversing the five-year capitalization rule that applied for 2022 through 2024. The credit and the deduction are distinct: one reduces tax dollar for dollar, the other determines timing of the expense.
What Section 174 Status Looks Like Now
For tax years 2022 through 2024, the Tax Cuts and Jobs Act forced taxpayers to capitalize and amortize research costs rather than deduct them immediately. Domestic costs were spread over five years and foreign costs over fifteen, with a mid-year convention that pushed real deductions even further out. That created phantom income for many capital-intensive manufacturers who were spending real cash on engineering but could only deduct a fraction of it.
The practical effect was a cash-flow squeeze. A manufacturer that spent heavily on engineering payroll in a given year still owed tax as if most of that spending had not happened, because only a sliver of the cost reduced taxable income in year one. Companies with thin margins felt this most acutely, and some scaled back development plans to manage the tax bill rather than the engineering need.
The One Big Beautiful Bill Act, signed July 4, 2025, added new Section 174A and reversed the domestic rule. For tax years beginning after December 31, 2024, taxpayers may fully expense domestic research or experimental expenditures in the year paid or incurred, according to Grant Thornton’s analysis of the OBBBA research provisions. Taxpayers may instead elect to capitalize and amortize domestic costs over a period of not less than 60 months, but immediate expensing is the default and the more common choice.
Foreign research expenditures did not get the same treatment. Costs for research conducted outside the United States must still be capitalized and amortized over 15 years, consistent with the prior Section 174 framework. That distinction matters for manufacturers with engineering teams or contract research abroad, because location now drives the deduction timeline.
Two transition items are worth flagging. Small businesses that meet the Section 448(c) gross receipts test, generally average annual gross receipts that do not exceed the inflation-adjusted threshold of $31 million tested for the first tax year beginning after December 31, 2024, may apply the new expensing rules retroactively to tax years 2022 through 2024. The IRS issued procedural guidance in Rev. Proc. 2025-28 on August 28, 2025, covering the elections and accounting method changes required to put Section 174A into effect. This retroactive relief carries a hard deadline: the small-business election must be made within one year of enactment, which falls on July 6, 2026, so eligible manufacturers should confirm timing immediately rather than wait for a normal filing cycle.
Larger manufacturers that do not meet the small-business threshold have a separate transition path. Rather than amending prior returns, they can recover the remaining unamortized domestic costs from 2022 through 2024 going forward, either fully in the first tax year beginning after December 31, 2024, or ratably across the first two such years. The mechanics differ from the small-business route, so the right move depends on company size and prior elections.
Qualifying Activities for the R&D Credit in Manufacturing
The credit under Section 41 is separate from the deduction. To count as qualified research, an activity must satisfy a four-part test set out in Section 41(d), and the burden is on the taxpayer to show every part is met. The IRS audit techniques guide for the research credit walks through each element in detail.
The first part is the Section 174 test: the expenditure must be eligible to be treated as a research or experimental cost. The second is the technological information test, meaning the work must rely on principles of the physical or biological sciences, engineering, or computer science. The third is the business component test, requiring the research to relate to a new or improved product, process, technique, formula, or invention used in the business or held for sale. The fourth is the process of experimentation test: substantially all of the activity must involve evaluating alternatives to resolve technical uncertainty.
Manufacturing work tends to map cleanly onto these requirements because so much of it is engineering driven. Common qualifying activities include the following:
- Designing and testing prototypes for new or improved products before they reach production.
- Developing or refining manufacturing processes to improve yield, reduce scrap, or increase throughput.
- Designing custom tooling, jigs, fixtures, molds, and dies where the outcome is technically uncertain.
- Evaluating new materials, coatings, or alloys for performance, durability, or regulatory compliance.
- Automating production lines, including programming and integrating robotics, controls, and sensors.
- Building and testing software that runs equipment or manages production data where functionality is uncertain at the outset.
The uncertainty requirement is the part manufacturers most often misjudge. Routine production, quality control of existing output, and cosmetic or seasonal style changes do not qualify because there is no technical uncertainty to resolve. The credit rewards the experimentation that happens before a process is proven, not the steady-state running of it once it works.
It also helps to think at the level of the business component, because the four-part test applies to each one separately. A single product launch might contain several distinct components: the part itself, the mold that forms it, and the automated cell that assembles it. One component can qualify even if another does not, so framing each effort precisely tends to capture more eligible work than treating a whole project as one undivided activity.
Which Costs Count Toward the Credit
Once an activity qualifies, the credit is computed on the qualified research expenses tied to it. There are three main categories of eligible cost, and they line up well with how a typical manufacturer staffs and supplies its development work.
Wages are usually the largest category. They cover the taxable compensation of employees who perform qualified research, directly supervise it, or directly support it. For a manufacturer, that often means process engineers, design engineers, and the production staff who run trial builds, along with the supervisors guiding the work.
Supplies are the second category and cover tangible property used and consumed in the research, excluding land and depreciable property. Raw materials and components scrapped during prototype runs and process trials commonly fall here. The third category is contract research, where 65 percent of amounts paid to outside contractors for qualified work performed on the taxpayer’s behalf may be included.
Because these calculations interact with payroll records, project tracking, and the new Section 174A treatment, manufacturers benefit from documentation built during the year rather than reconstructed at filing. The IRS treats research credit claims as a high-scrutiny issue, so contemporaneous project records, time tracking, and technical notes are the difference between a defensible claim and a disallowed one. Our tax advisory services team helps manufacturers set up that tracking before the work happens, and our manufacturing practice understands how shop-floor activity translates into qualified expenses.
Good records also resolve the gray areas that surface in every manufacturing operation. Engineers split their time between qualified development and routine support, and supply runs mix prototype scrap with ordinary production waste. A tracking system that ties hours and materials to specific business components turns those judgment calls into documented allocations, which is exactly what holds up if the claim is examined.
How the Credit and the Deduction Work Together
The credit and the Section 174 deduction apply to overlapping costs, so they have to be coordinated. A wage paid to a process engineer can support a Section 41 credit and also be a domestic research expenditure deductible under Section 174A. Claiming both is allowed, but the law prevents a double benefit on the exact same dollars.
Under the rules, a taxpayer who claims the full research credit generally must reduce its deductible research expenses by the amount of the credit, unless it makes a reduced credit election under Section 280C. The reduced election lets the taxpayer keep the full deduction while taking a smaller credit, reduced by a percentage tied to the top corporate tax rate. Which option produces the better result depends on the company’s tax rate and overall position, so it is a modeling exercise rather than a default choice.
There is also a payroll tax option that matters for newer manufacturers. A qualified small business may elect to apply a portion of its research credit against the employer share of payroll taxes rather than income tax, which helps early-stage companies that are not yet profitable. The election is made on the return and has its own eligibility limits tied to gross receipts and years in operation.
The practical takeaway is that 2025 and 2026 are planning years, not routine filing years. The return to immediate domestic expensing, the time-limited retroactive relief for small businesses, and the transition rules from the prior capitalization regime all interact with the credit. Manufacturers should revisit prior-year positions and current-year tracking together rather than treating the deduction and the credit as separate exercises.
Frequently Asked Questions
Is Section 174 capitalization still required in 2026?
No, not for domestic research. For tax years beginning after December 31, 2024, Section 174A allows full expensing of domestic research or experimental expenditures in the year paid or incurred. Foreign research expenditures are the exception and must still be capitalized and amortized over 15 years.
Can a manufacturer claim the R&D credit and deduct the same costs?
You can claim both the Section 41 credit and the Section 174A deduction on overlapping costs, but you cannot get a double tax benefit on the same dollars. You either reduce your deduction by the credit amount or make a Section 280C election for a reduced credit and keep the full deduction. The better choice depends on your tax rate and overall position.
What manufacturing activities qualify for the research credit?
Activities qualify when they pass the four-part test in Section 41(d): a permitted purpose tied to a business component, reliance on hard science or engineering, technical uncertainty, and a process of experimentation. Typical qualifying work includes prototype development, process improvement, custom tooling design, materials testing, and production automation. Routine production and ordinary quality control do not qualify.
Can small manufacturers recover R&D costs from 2022 through 2024?
Possibly. Businesses meeting the Section 448(c) gross receipts test, generally an inflation-adjusted average annual gross receipts threshold of $31 million tested for the first tax year beginning after December 31, 2024, may apply the new expensing rules retroactively to 2022 through 2024. Rev. Proc. 2025-28 sets out the procedures, and the election must be made within one year of the law’s enactment, by July 6, 2026, so timing should be confirmed before relying on this relief.
