R&E Capitalization Has Unintended Effect on Small Businesses
The Tax Cuts and Jobs Act (TCJA) brought a significant, albeit delayed, change to the tax treatment of research and experimentation (R&E) costs under Internal Revenue Code Section 174. After the law was enacted, many tax experts mistakenly expected that Congress would intervene before the amendment took effect.
Instead, the changes became effective in 2022, and the repercussions have proven harsh, especially for small businesses. While IRS guidance that was released in 2023 may provide some relief, it has not reversed the adverse fallout.
Old Rules
Before the TCJA went into effect, a business could either:
Deduct R&E expenses in the year they were incurred, or
Capitalize and amortize the costs over a minimum of five years.
Software development costs could be immediately expensed. Or they could be amortized over five years from the date of completion or amortized over three years from the date the software was placed in service.
R&E expenditures generally include research and development (R&D) costs in the experimental or laboratory sense. Applicable costs are those related to activities intended to discover information that would eliminate uncertainty about the development or improvement of a product, including salaries.
Important: Sec. 174 defines R&E expenditures more broadly than the way R&D expenses are defined for purposes of the Sec. 41 R&D tax credit. So, costs that are not covered by the credit may still be considered R&E expenditures. That means Sec. 174 can apply to a business regardless of whether it claims the credit.
New Rules
Starting in 2022, businesses no longer have the option to deduct so-called “specified R&E expenses” (those paid or incurred during the tax year). Instead, they must amortize these costs over five years if incurred in the United States or 15 years if incurred outside the country. Amortization continues even if the underlying property is disposed of, retired, or abandoned during the applicable period. In addition, software development costs now must be treated as Sec. 174 expenses.
Making matters even more complicated is a provision requiring that the amortization period begin in the midpoint of the tax year in which the expenditures are incurred or paid. As a result, taxpayers can deduct only 10% of expenses in the first year and 20% of expenses in years two through five, with the remaining 10% deducted in year six.
How the Changes Affect Businesses
Many business owners now find themselves facing dramatically larger tax bills than they have in the past, when they could immediately deduct 100% of R&E costs in the year incurred. Without the full deduction, they may end up reporting taxable income — even if they had a loss.
The new tax treatment has hit the life sciences and technology industries particularly hard. Their tax liabilities, including quarterly estimated tax payments, are taking huge or even debilitating bites out of their cash flow and threatening continued operations. The loss of hefty current deductions also means these businesses lose out on reinvestment opportunities.
With big tax bills looming, some businesses that have limited access to capital have had to resort to tapping personal financial resources (for example, credit cards, savings, or lines of credit) to meet their obligations. Others have had to weigh layoffs, hiring freezes, and the possibility of putting a pause on critical projects.
IRS Steps In
The IRS issued guidance in the fourth quarter of 2023 and has promised forthcoming proposed regulations on revised Sec. 174. While the guidance has not modified the TCJA amendment, it has provided some helpful clarification. It identifies several types of costs that are not considered R&E expenditures. Examples include those for general and administrative service departments that only indirectly support or benefit R&E activities (such as payroll and human resources).
The guidance also aims to help taxpayers determine whether certain activities constitute software development costs. For example, costs that are related to software development activities or to the installation of purchased software are not subject to Sec. 174, but costs for upgrades and enhancements to such software are.
Potential Legislative Relief
The IRS guidance has answered some questions regarding the proper application of Sec. 174. However, many more questions remain, along with concerns that the TCJA's change may deter R&E activities. Congress appears to have taken notice.
In January 2024, the House passed the Tax Relief for American Families and Workers Act (H.R. 7024) by a vote of 357-70. Among other things, the bill would temporarily restore the previous Sec. 174 immediate expensing option, through 2025, on a retroactive basis for domestic R&E expenses. But the option would not be available for foreign R&E. The Senate has yet to vote on the bill.
Time to Strategize
Unlike many provisions in the TCJA, the amendment to Sec. 174 is permanent, and even enactment of the Tax Relief for American Families and Workers Act in its current form would simply delay implementation of the change.
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