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R&D tax credits for manufacturing can significantly reduce business costs and increase cash flow. By reducing the tax burden associated with research and development activities, these credits provide manufacturers with the necessary resources to reinvest in their businesses. The process for claiming these credits can be complex and tedious, and many manufacturers fail to take full advantage of available credits or overlook them altogether. In this blog, we will discuss the basics of R&D tax credits for manufacturing, how they can benefit your business, and what steps you can take to ensure you maximize your credit.
If you find the claims process for R&D tax credits intimidating, you’re not alone. Partnering with a firm that offers accounting services for small businesses, such as Haven, can help make the process easier and more efficient. We help manufacturers and other small companies identify qualifying activities and expenses before assisting with the claims process to ensure you maximize benefits.
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Recent Changes Regarding Section 174 and How It Applies to Manufacturers
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Understanding the R&D Tax Credit for Manufacturing
The R&D tax credit for manufacturing offsets the costs of innovation. The credit is a federal incentive designed to reward businesses that invest in research and development activities to improve their processes or products. While many people assume the credit only applies to tech companies, manufacturers are among the biggest beneficiaries, often without even realizing it.
Why the R&D Tax Credit Matters for Manufacturers
Innovation is costly. Tooling, prototypes, software systems, labor, and raw materials used during development can quickly add up. The R&D tax credit helps offset those costs, freeing up cash to reinvest in further innovation or growth. Better yet, manufacturers can apply the credit to both federal and state tax liabilities, and in some cases (for qualified small businesses and startups), even offset payroll taxes, which is particularly valuable if your business is still pre-profit or reinvesting aggressively.
Don't Leave Money on the Table
Unfortunately, many manufacturing businesses miss out simply because they don't realize they qualify, or they assume R&D means something more high-tech than what they’re doing. But if you're solving technical challenges and improving your processes or products, you likely already qualify. By working with tax professionals who understand the nuances of Section 41 (R&D Tax Credit) and Section 174 (amortization rules), you can identify:
Qualifying activities
Properly document your efforts
Claim the maximum benefit available
R&D Tax Credits for Manufacturing: A Strategic Advantage
The R&D tax credit is more than a deduction; it's a strategic advantage. For manufacturers who innovate, iterate, and improve, it's a way to turn your investment in innovation into lasting financial value.
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How to Qualify for the R&D Tax Credit for Manufacturing
Suppose you’re a manufacturer investing time and resources into developing new products, improving production processes, or creating prototypes. In that case, you may already be eligible for the R&D tax credit, even if you don’t realize it. But to claim it, your activities must pass the IRS’s four-part test, along with meeting some industry-specific requirements.
The Four-Part Test for R&D Credit Eligibility
The IRS has a four-part test for determining whether or not research activities qualify for the R&D tax credit. Activities must meet all four criteria to be eligible for the credit.
1. Product or Process Improvement
Your work must aim to improve the function, performance, reliability, or quality of a product or production process. This could involve designing a new assembly line, enhancing material usage, or reducing manufacturing cycle time. Typical qualifying activities include:
New product development
Process optimization
Prototyping and iterative testing
Be aware:
Efforts involving reverse engineering, simple customization, or modifications at a customer’s request generally do not qualify.
2. Technological in Nature
The work must rely on principles of the hard sciences, such as:
Engineering
Physics
Chemistry
Computer science
Activities rooted in social sciences or business disciplines (e.g., marketing or financial modelling) don’t qualify.
3. Technical Uncertainty
You must have faced uncertainty during the project, not knowing how or if a product or process could be developed or improved. This includes uncertainty around:
Capability
Method
Design
4. Process of Experimentation
There must be evidence of a systematic trial-and-error process to resolve the uncertainty. This can include:
Prototyping
Modeling
Testing
Other iterative development efforts
For manufacturers, a formal product development lifecycle can often support this requirement.
Key Considerations for Manufacturers
Time and Activity Tracking
Accurate tracking of time and roles is essential. While engineers and designers often log hours by project, supporting departments, such as tooling, prototyping, and QA, may not. Ensure all staff involved in qualified activities understand what qualifies, and document it accordingly.
IRC Section 174 & Pilot Models
Under Section 174, supply costs associated with pilot models used for evaluation or testing are eligible. For manufacturers, this means a well-documented business component and a clearly defined pilot model can unlock substantial supply cost credits.
ASC 730 Safe Harbor (For Large Manufacturers)
If your business uses the U.S. GAAP and prepares financial statements, you may qualify for the ASC 730 Safe Harbor method. This allows you to use your financial reporting R&D expenses as a base for the tax credit, reducing the burden of detailed project documentation.
Qualified Startup Payroll Offset
If your company is a qualified small business (less than $5 million in gross receipts and within its first five years of revenue), you can apply up to $500,000 in R&D credits against payroll taxes. This is particularly valuable if your business isn’t yet profitable.
Note:
You’ll need to carefully assess “controlled group” status to ensure combined gross receipts stay under the $5 million cap.
AMT Offset
For tax years beginning after December 31, 2015, eligible small businesses (those with $50 million or less of gross receipts) may claim the research credit against AMT liability.
State-Level R&D Credits
Many states offer their own R&D tax incentives, with some allowing refunds or transfers of credits even if you have no income tax liability. Timelines vary, and some states require separate applications; therefore, plan accordingly. States like New Jersey and Massachusetts now offer simplified credit calculation methods, making access easier.
Examples of Qualifying R&D Activities
The scope of qualifying activities is broader than most manufacturers expect. To be eligible, your activities must aim to improve a product or process and involve some level of technical uncertainty and experimentation. Some common examples of qualifying R&D activities in manufacturing include:
Improving production efficiency through automation or lean processes
Designing and prototyping new products or tools
Developing or customising software for internal use (e.g., inventory systems or manufacturing execution systems)
Testing alternative materials to reduce costs or improve product durability
Scaling up production processes from prototypes to full-scale manufacturing
Refining quality assurance procedures for new products
Determining tooling requirements and optimal placement of equipment
Developing processes that meet stringent regulatory requirements
Developing prototypes using computer-aided design (CAD) and computer-aided manufacturing processes
Developing robotics and automated technology
Experimenting with new or improved filling and packaging techniques
Even if your project fails, the effort may still qualify for credit; what matters is that you tried to solve a technical problem using a structured, science-based approach.
Recent Changes Regarding Section 174 and How It Applies to Manufacturers
The Game-Changer: R&D Capitalization
Section 174 of the Internal Revenue Code underwent a significant shift as a result of the Tax Cuts and Jobs Act (TCJA), passed in 2017. Although its impact was delayed, the changes took effect for tax years beginning after December 31, 2021, and significantly altered how manufacturers and other research and development (R&D)- intensive businesses must handle their R&D costs.
The Key Change: No More Immediate Deduction
Before the TCJA, manufacturers could fully deduct qualifying R&D expenses in the year they were incurred. This provided businesses with an immediate tax benefit and enhanced their cash flow. Now, under the new Section 174 rules, those same Specified Research or Experimental (SRE) expenditures must be capitalised and amortised over five years for U.S.-based R&D (or 15 years for non-U.S. R&D), using a half-year convention. This means companies can only deduct a portion of their R&D spend in the year it is incurred, specifically 10% in the first year, with the remainder spread out over the next several years.
Why This Matters to Manufacturers
Manufacturers often conduct R&D as part of product design, process improvement, and production innovation, all of which typically fall under Section 174. With the new rules in place, these R&D activities now result in larger taxable income in the short term, potentially leading to higher tax bills despite no change in operations. For capital-intensive manufacturers, this change affects cash flow, financial forecasting, and even investment decisions. It also creates a disconnect between economic activity and tax treatment, since you may not see the tax benefit from your innovation until years later.
How R&D Tax Credits Help Offset the Impact
While the new Section 174 rules increase short-term tax burdens, businesses conducting qualifying R&D under Section 174 may also be eligible for R&D tax credits under Section 41. These credits provide a dollar-for-dollar reduction in tax liability, helping to mitigate the cash flow crunch caused by the capitalization requirement. In essence, if you’re a manufacturer now required to amortize your R&D costs, you should also be exploring and optimizing your R&D tax credit strategy. These credits can’t eliminate the amortization rules, but they can reduce your overall tax liability and make the transition more manageable.
What’s Next?
There are ongoing legislative efforts, such as the American Innovation and R&D Competitiveness Act of 2025, aimed at reinstating immediate expensing for R&D costs. If passed, it could reverse the Section 174 amortization requirement, restoring the deduction benefits manufacturers once relied on. But until that happens, compliance with the current rules is essential. In the meantime, manufacturers should:
Identify and classify all SRE expenses accurately
Ensure Section 174 compliance while preparing tax filings
Leverage R&D tax credits to reduce the impact
Monitor legislative updates that could affect future filings
Navigating the Section 174 changes is complex, but for manufacturers, the right combination of compliance and proactive tax strategy can help minimize the downside.
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Maximizing Your R&D Tax Credits
Maximising your R&D tax credits isn’t just a box-ticking exercise at tax time; it’s a strategic lever for innovation and financial flexibility. At its core, the R&D tax credit is a powerful tool that can improve:
Cash flow
Reduce tax liabilities
Facilitate reinvestment in growth
Commonly Overlooked R&D Activities in Manufacturing and Tech
Yet many businesses underestimate its scope. R&D credits aren’t limited to lab work or formal product development.
Eligible activities often include:
Software development
Process optimization
Prototyping
Testing
Iterative problem-solving
The key is looking beyond the obvious. In industries such as manufacturing, engineering, and technology, qualifying work is often embedded in day-to-day technical challenges, usually hidden in plain sight.
Document Everything and Then Document Some More
Documentation is everything. Whether you're a startup claiming payroll tax offsets or a mature company reducing income tax liability, detailed records will make or break your claim. Track your R&D goals, the technical uncertainty you’re tackling, the steps you took to resolve it, and all associated costs, from wages to contractor fees to materials. Good documentation doesn’t just support your claim; it protects you in the event of an audit.
Partner with R&D Tax Credit Experts
Tax law is complex, and R&D credits are no exception. Partnering with professionals who specialise in R&D tax credits can dramatically improve both the size and accuracy of your claim. These experts understand how to structure your activities, apply the right methodologies, and help you qualify for credits you might otherwise miss, especially across multiple tax years or jurisdictions.
Make R&D Tax Credits Part of Your Annual Strategy
Don’t treat the R&D credit as a one-off windfall. Build it into your financial and operational reviews every year. As your business grows, your eligible activities are likely to change, and with legislation evolving staying proactive is essential, like:
Amortization rules
Payroll offsets
Reporting thresholds
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R&D capitalization is similar to other types of asset capitalization. When a company spends money on an asset, such as a piece of machinery or a building, it deducts those costs over time as the asset depreciates rather than taking the full deduction all at once. An R&D tax credit helps a business reduce its tax liability. When a company qualifies for a tax credit, it can deduct the amount of the credit from what it owes in taxes. Capitalizing R&D costs means the business can write off these expenses over time when calculating its tax obligations, rather than taking a full deduction in the first year. Writing off R&D costs over time instead of taking a full deduction can help a business reduce its tax liability even further.