If your organization invests heavily in research and development, recent legislative changes could significantly impact your cash flow and incentives to invest in innovation moving forward.
Here is what you need to know about what these changes to R&D expenses will mean for your organization.
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The Basics of Section 174 and Tax Incentives for Research and Development
Since 1954, Section 174 of the federal tax code has allowed businesses to deduct qualified research expenses in the year they incurred those costs.
Congress also created thein 1981. Together, these elements of the tax code act have been highly effective as an incentive for investing in innovation.
According to an analysis by the Centre for Economic Policy Research (CEPR), R&D tax incentives make companies more likely tostart or continue investing in research and development—especially in small- to medium-sized companies.
Recent Significant Changes Made to Section 174 and Research Expense Deductions
As part of the Tax Cuts and Jobs Act of 2017 (TCJA), Congress changed how businesses write off R&D expenses.
Starting in 2022, companies can no longer write off 100% of costs in the year they were incurred. Instead, to comply with these new rules, companies must amortize most of those costs over five years (15 years for R&D expenses attributed to foreign research).
Lawmakers made this change to help pay for the tax cuts included in TCJA.
The first year is the toughest, as businesses can deduct only 10% of their 2022 domestic research costs on their 2022 tax returns.
For some businesses that invest heavily in research and development, the change in Section 174 has resulted in large and unexpected tax bills when filing their 2022 federal income tax returns. Companies that broke even or even sustained net losses for book purposes in 2022 find that their taxable income is much higher without the ability to write off R&D expenses in the year incurred.
For example, say a company has $2 million in revenue, $1 million in qualified research and development costs and $1 million in other deductible expenses. Under the old system, the company would have zero profit and owe no income taxes.
However, under the new changes to Section 174, the company can only deduct $100,000 of its research costs, so the company (or its owners) would owe federal income taxes on $900,000 of taxable income.
In addition, because most states conform to or follow the new rule under Section 174, businesses may see an increase in their tax liabilities at the state level.
This change has been on the horizon since 2017, but many business owners and their advisors assumed Congress would change the law before it took effect.
Several legislative proposals have attempted to delay or repeal the requirement to amortize research and development expenditures, but to date, none have passed.
Is Relief on the Horizon for Business Owners? (What May Come)
Congressional negotiators are working on a tax package that includes a proposal to delay this capitalization and amortization and reinstate immediate deductibility, but it is still in the legislative process.
The American Institute of Certified Public Accountants, the American Council of Engineering Companies, the American Institute of Architects, the National Association of Manufacturers and several other groups represent industries that are actively encouraging Congress to approve a repeal or a multi-year delay of the amortization requirement.
While members of both parties support reversing the Section 174 capitalization and amortization requirements, they are divided on how to do it.
What Happens if the Change to Section 174 Capitalization and Amortization IsNotOverturned?
Section 174 is the law and will be mandatory for organizations to implement, even though many taxpayers are likely to see negative impacts quickly.
Even if your company does not take the R&D tax credit, you may still be subject to the mandatory Section 174 capitalization and amortization requirements. If you have claimed a deduction for R&D expenses in the past, you are required to follow these new capitalization rules.
Legislation that overturns this change is not a guarantee, so it is important that every taxpayer assess the facts, review the IRS guidance and anticipate the business impact now.
What Does Compliance with Section 174 Look Like Now?
The IRS has published guidance (Notice 2023-63) to help answer many questions for companies about how to comply. It clarifies several areas of uncertainty for implementing the revised Section 174.
Below, we have summarized how the new guidance impacts compliance with Section 174.
The IRS subsequently issued Notice 2024-12 which clarified and modified the interim rules issued in Notice 2023-63.
One of the most crucial modifications is that the finalized guidance removes the requirement for taxpayers to apply all the rules from Notice 2023-63; instead, they can rely on any of the rules in the Notice. This allows an organization to choose to rely on the proposed rules in Notice 2023-63 (as modified by Notice 2024-12) that benefit it.
Previously, taxpayers could rely on the interim guidance in Notice 2023-63 only if they implemented all the rules provided in the Notice and applied them in a consistent manner.
SRE expenditures
The types of costs eligible as capitalizable specified research and experimental (SRE) expenditures vary from company to company, so the IRS has not provided (and likely will not provide) an exhaustive list of qualifying costs.
However, the Notice provides some examples of cost categories. Some notable categories include all aspects of compensation (other than severance), travel costs and overhead (rent, utilities, depreciation, security costs, insurance, taxes, maintenance, etc.).
The Notice also mentions some specific exclusions to Section 174, including the costs of service departments that only indirectly support SRE activities, such as human resources or accounting and interest on debt used to finance SRE activities.
Section 3 of Notice 2024-12 clarified the interim guidance by providing a definition of “an excluded SRE product right” as an SRE product right that:
- Is separately bargained for or
- Was acquired for the limited purpose of performing SRE activities under the contract (or another contract with the research recipient).
Software development
The Notice clarifies the scope of software development related to Section 174 capitalization, centering around two primary concepts:
- First, databases are not software, and data entry is not software development.
- Second, an item’s ready-for-sale date (or placed-in-service date) is pivotal. Before that date, the scope of capitalizable software development is broad and captures a range of activities. However, the scope is limited after that date unless the activity involves material software upgrades or enhancements.
Research performed under contract
The Notice addresses who incurs SRE expenditures when research is performed under contract—the research provider, recipient or both. According to the Notice, the research provider is only subject to Section 174 if they carry either financial risk associated with the project or retain some rights to the research product.
Dispositions
Taxpayers may need to continue amortizing expenditures after disposing of, retiring or abandoning related property.If property tied to SRE expenses is disposed of, retired or abandoned during its amortization period, the taxpayer cannot recover any unamortized SRE expenses but must continue to amortize them over the set period.
Long-term contracts
Prior to the Notice, there was some confusion over research associated with contracts subject to the percentage of completion method—specifically, whether a taxpayer’s completion factor must include the gross amount of SRE expenditures the taxpayer incurs in a particular year.
IRS Revenue Procedure 2024-9 provides two options for organizations to capture the amortization of SRE costs within the completion factor’s numerator:
- Include all amortization of SRE expenses that directly benefit or are incurred to perform the long-term contract, or
- Include only the portion of SRE expense amortization the company expects to incur and deduct during the contract term.
Despite this clarification, it’s unclear whether the IRS will retain these options in the proposed regulations we expect the IRS to issue later this year.
Cost-sharing agreements
The IRS intends to change the rules for how payments apply to costs, and some payments might now be treated as income. Ensure you are tracking these payments and applying them correctly.
How Should Your Company Respond to the Section 174 Capitalization and Amortization Changes?
For now, businesses with research and development expenses need to seek guidance from experts who understand the subtleties of Section 174 and can help navigate the changing landscape.
If you want to learn more about how capitalizing and amortizing research costs will impact your business, connect with your Warren Averett advisor directly, orask a member of our team to reach out to you.
This article was originally published on March 3, 2023, and most recently updated on January 25, 2024.
Topic , Tax
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