A Business’ Guide to Research & Experimental (R&E) Expensing Changes

In recent years, lawmakers have significantly changed the treatment of Research & Experimental (R&E) expenditures for federal income tax purposes. These changes stem from a provision of the Tax Cuts and Jobs Act (TCJA) of 2017 that took effect on January 1, 2022.

In this guide, we’ll explore the changes to Section 174 of the Internal Revenue Code (IRC), recent guidance from the Internal Revenue Service (IRS), and state responses to these changes to help you understand how these changes to writing off research and experimental expenditures might affect your business.

Federal Changes to Section 174

IRC Section 174 has existed since the 1950s. It allows businesses to deduct qualified research expenses in the year they incur them.

Research and experimental expenditures include costs the company incurs to develop or improve products or processes or software development costs.

In 1981, Congress created the Research and Development (R&D) Tax Credit (IRC Sec. 41) to further encourage businesses to invest in innovation. The list of reasonable research expenditures eligible for Section 174 expensing is broader than that of the R&D tax credit, including direct and indirect R&D expenses, overhead expenses, software development costs, and international research activities.

Together, these tax incentives have effectively boosted R&D in the United States. Research published in the Journal of Public Economics found that a 10% reduction in the use cost of R&D leads the average organization to increase its research intensity—the ratio of R&D spending to sales—by 19.8% in the short run.

Pre-TCJA Treatment

Prior to the TCJA’s changes to Section 174, businesses had the option to either deduct R&E expenditures in the year incurred or capitalize and amortize them over 60 months.

Post-TCJA Treatment

For taxable years beginning after December 31, 2021, businesses no longer have the option to write off 100% of research or experimental expenditures in the year they were incurred. Instead, they must capitalize and amortize them over five years for domestic research and fifteen years for foreign research.

This change has several implications for companies that engage in research activities, including:

• Cash flow. Businesses must capitalize all R&E expenditures rather than writing off such spending immediately. This can negatively impact cash flow and financial planning.
• Delayed tax benefits. The mandatory amortization periods (five or 15 years) delay the tax benefits previously available under the immediate expensing option.
• Unexpected tax bills. The first year under the new Section 174 expensing rules was the most challenging for companies with qualified research activities. They could only deduct 10% of their costs for research conducted in the U.S. on their 2022 tax year returns. For many organizations, this resulted in significant and unexpected tax bills. Some companies with losses for book purposes found they had substantial taxable income without the option to write off those experimental expenditures.

Amortizing Research or Experimental Expenditures: An Example

Let’s consider an example to illustrate how capitalizing research and experimental expenditures might impact a business’s tax liabilities.

Company A has $2 million in revenue, $1 million in qualified research and development costs, and $1 million in other deductible expenses.

Under prior guidance, Company A would have zero profit and owe no federal income tax.

Assuming the same R&E investments and results of operations in 2022, the company could only deduct $100,000 of its research or experimental expenditures. As a result, the company (or its owners, in the case of an LLC or S Corporation) would owe federal income taxes on $900,000 of income.

State Conformity to IRC Section 174 R&E Capitalization Rules Varies

States vary in their approach to applying the federal changes in R&E expensing. Most states have conformed to the federal changes, meaning businesses must capitalize and amortize experimental expenditures in the same manner as on the federal return when calculating state tax liabilities.

However, there are a few exceptions. The state approaches to Section 174 changes fall into three categories:

• Conform with the IRC in effect after enacting the Tax Cuts and Jobs Act. Companies filing in these states don’t need to adjust their state taxable income based on the federal treatment of Section 174 because these states either amended their tax codes to follow the federal rules or have “rolling conformity” to automatically adopt federal changes as they occur.
• Confirm to the IRC in effect before enacting the TCJA. In California and Georgia, the state tax code follows the federal tax law in effect before the TCJA’s changes to Section 174. Companies can still deduct experimental expenditures paid or incurred in that tax year.
• Specific exceptions to the Section 174 capitalization changes. Tennessee, Indiana, and Wisconsin enacted legislation after the TCJA was signed into law, confirming they would not follow the Section 174 changes that went into effect for tax years beginning in 2022.

This decoupling creates complexities for businesses in the second and third categories as they navigate differing federal and state tax treatments. These businesses must adjust their income for state tax purposes to allow for expenses that must be capitalized on their federal tax returns and track book-to-tax differences in amortization going forward.

More states may enact decoupling laws in upcoming legislative sessions, so businesses should work with a tax professional who can help them stay informed about the specific rules in each state where they operate to ensure accurate tax reporting and planning.

Are More Section 174 Legislative Changes on the Horizon?

In 2023, House lawmakers introduced the Build It in America Act (H.R. 3938). The proposed regulations would reinstate the immediate deductibility of Section 174 expenses and delay the amortization requirement until 2026. While the legislation passed along party lines in the House, it seems to have little chance of getting through the Senate in its current form.

While there is bipartisan support for reversing the Section 174 capitalization requirements, lawmakers are divided on how to accomplish it.

In the meantime, the IRS published substantive guidance in Notice 2024-12 to help answer several common questions about compliance. Some of the issues addressed by the IRS guidance include:

• Examples of SRE expenditures. The notice provides examples of specified research and experimental expenditures, including compensation, travel costs, and overhead. It also outlines some specific exclusions, including the cost of service departments that only directly support SRE activities and interest on debt used to finance SRE activities.
• Scope of software development. The Notice clarified the scope of software development for Section 174 capitalization.
• Research performed under contract. The Notice addressed those who incur SRE expenditures for activities performed under a research contract by clarifying that research providers are only subject to Section 174 if they carry financial risk associated with the activities or benefit from the research product.
• Dispositions. If property tied to SRE expenditures is disposed of, retired, or abandoned during its amortization period, the company cannot recover any unamortized experimental expenses. Instead, it must continue to amortize them over five or 15 years.

Strategic Considerations for Businesses with Research or Experimental Expenditures

The changes to the treatment of research and experimental expenditures introduced by the TCJA can create cash flow and financial forecasting challenges for businesses. Strategic planning, effective record-keeping, and trusted advice from a tax advisor can help you understand federal and state requirements, ensure compliance, and manage your tax liabilities.

For more detailed guidance and specific advice tailored to your business, contact Percipio Business Advisors. Our experienced advisors can provide insights into federal and state tax implications and offer strategies to optimize your tax position.

Connect with us today