The explosion in AI is so huge that it’s boosting the entire country’s economy. Companies like OpenAI, Perplexity, and Anthropic have seen remarkable growth. And if your company is leaning into AI or machine learning (ML), you’re probably hoping to realize some of that upside for yourself.
If you’re undertaking R&D to develop an AI or ML product or service, that effort could offer some financial benefit, whether the research pans out or not. Thanks to the federal R&D tax credit (Section 41 of the Internal Revenue Code [IRC]) and deduction (IRC § 174), you could slash what you owe to the IRS.
To claim that credit and deduction, though, you need to approach the R&D in some specific ways. Because we specialize in helping tech companies tap into these tax savings, we can help. Here’s what you need to know about the way these parts of the IRC interplay with ML or AI R&D.
Deducting eligible R&D expenses
With the passage of the One Beautiful Big Bill Act — simply called “the Act” by the time it was passed — the way American companies can deduct their domestic R&D expenses changed.
Specifically, the Act removed an amortization requirement for those expenses. Companies used to have to amortize them over five years. Under the now-updated version of IRC § 174, you can immediately deduct eligible domestic R&D expenses from your tax bill.
And that’s not the only way you can use those expenses to reduce the amount you need to hand over to the IRS, either. An earlier section of the IRC lets you claim a credit to further reduce your tax liability.
What’s required to qualify for the R&D tax credit
IRC § 41 lays out the federal tax credit for qualified research expenses (QREs). The more your company spends on these QREs, the bigger the credit you can claim.
Under the Internal Revenue Code, something can count as a QRE if it passes the four-part test. It needs to:
- Be directly linked to your business and used to help your company eliminate uncertainty
- Be technological in nature (i.e., use hard science)
- Aim to develop a new product or service for your company (not iterate on an existing one)
- Use a process of experimentation
For AI and ML companies, this can get fairly complicated depending on the type of R&D you’re undertaking.
If you’re creating a new LLM, for example, the costs around it probably largely qualify for the credit.
But let’s say you’re creating a new user interface that leverages an existing LLM. The cost associated with the part of your team’s work that goes to develop something new can count toward this tax credit. You’ll need to clearly delineate where the LLM’s work ends and your new research and experimentation begins, though. Thorough recordkeeping becomes particularly important.
The big takeaway here: if you’re working on creating new AI or ML technology, at least part of the cost of those activities can probably help to lower your tax bill.
Common categories of qualified research expenses for AI R&D
Qualified research expenses can come from a number of different categories. For most tech companies developing ML and AI products or services, the largest dollar amounts usually lie in these two areas:
Payroll
The wages you pay to people as they work on qualified R&D activities can count toward your credit.
Again, recordkeeping is critical here. You might have some staff that’s solely dedicated to R&D, and you can apply their whole salary. In a lot of cases, though, only a portion of the employee’s time is focused on qualifying research activities. Having a thorough log of what time was spent and on what activity helps you substantiate the credit for the IRS.
It’s also important to note that location matters here. For salaries or hourly wages to get applied to your credit, they need to be paid to employees who are working in the U.S. If you hire R&D personnel abroad, their portion of your payroll won’t count toward your credit.
Compute
AI and ML companies spend a sizable chunk on cloud computing services. The good news is that any portion of that you’re using for R&D can potentially be applied to your credit.
This is particularly true if you’re using an AI system in which team members use a credit with each query. Over the course of R&D, they might use thousands of credits. Carefully tracking those queries and their associated costs helps you bolster your R&D tax credit. As an added benefit, they’re likely deductible under IRC § 174, too.
The Act’s changes to that part of the Internal Revenue Code might change how your company approaches computers. Some computer rental expenses count as qualified research expenses. Buying the computer rather than renting moves it into the IRS category of a depreciable asset. That disqualifies it from the R&D tax credit.
Still, because immediate expensing of that purchase has been restored by the Act, your company can see a tax benefit from buying through the 100% bonus depreciation starting with tax year 2025.
The right option for your company depends on your short and long-term financial goals and computing needs. Your accountant can help you determine whether renting or buying offers you a better tax advantage.
Applying the credit to your tax bill
The R&D tax credit doesn’t give you a dollar-for-dollar reduction. Instead, you can claim a certain percentage of the total expenses. The amount you can claim depends on which calculation method you use: the regular credit or the alternative simplified credit (ASC). Again, your accountant can help you decide which option is best for your company.
All companies have the option to apply the R&D credit amount they ultimately receive to reduce their income tax bill.
But if you’re a qualified small business (QSB), you have another option. You can use it to reduce your payroll taxes (e.g., Social Security, Medicare) by up to $500,000. This is particularly advantageous to AI and ML startups that are operating at a loss (pre-profit). Applying the credit to your payroll tax lets your company realize savings even when you don’t have any income tax liability. However, it is essential to collaborate with your accountant to determine the timing of receiving a benefit from the credit, as the credit is applied prospectively to future payroll taxes, not retroactively to payroll taxes already paid. Conducting some cash-flow modeling can help determine the best course of action.
We can help with all of this. For support tracking qualifying R&D expenses to maximize the deduction and tax credit, calculating the size of your credit, and deciding how to apply it, contact us.
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