ARTICLE | January 10, 2025

The sweepingly significant Tax Cuts and Job Act (TCJA)(enacted in 2017) contained a provision not scheduled to come into effect until tax years beginning after December 31, 2021. This provision affects the timing for deduction of research and experimental (R&E) expenditures and could have a major impact on affected entities. At the time of release of this summary, Congress has not passed legislation that will repeal or defer the changes to the (R&E) expenditures imposed by TCJA. As a result, in September of 2023, the IRS issued a notice to provide guidance on challenges taxpayers have had since this provision of the law came into effect. Unfortunately, the notice potentially makes a bad situation worse for taxpayers who are trying to stay competitive and innovative.

What Costs are Impacted that are Defined Under Section 174?

Expenditures that fall under Section 174 represent specified research or experimental (SRE) expenditures if they are for activities intended to discover information that would eliminate uncertainty in product and process development. Expenses are categorized into either, “in-house research expenses” or, “contract research expenses,” and can include all relevant costs for developing prototypes, pilot models, formulas, inventions and techniques.

SRE expenditures are more expansive than “qualified research expenses” under Section 41 (used to calculate the R&E credit). SRE expenditures also include expanded labor costs, travel costs, overhead costs, depreciation of property used in connection with research and the costs of obtaining a patent.

R&E Expenses Before 2022

Section 174 introduced by TCJA clarifies the treatment of SRE expenditures. Prior to the changes in Section 174, taxpayers had the option to immediately expense or capitalize the costs as summarized below.

• Immediately deduct SRE expenses as they were incurred;
• Amortize and deduct them ratably over a period of at least 5 years beginning with the month the taxpayer first realizes benefits from the expenditures; or
• Amortize and deduct them ratably over a period of 10 years for alternative minimum tax (AMT) tax purposes.

R&E Expenses Starting in 2022

Starting in 2022, rather than having the option to immediately deduct costs related to research and experimentation, taxpayers will now be required to capitalize and amortize SRE expenditures over a 5-year period (15-year period for foreign research).

• Is there an advantageous opportunity for you to acquire or purchase property or software related to your research, instead of developing it yourself? Acquired assets with short depreciation recovery periods may be eligible for bonus depreciation.
• Do you have an appropriate system to identify your SRE expenditures, including software development costs, by location?
• If your company has not yet taken the R&E tax credit before, there may be more incentive now than ever before to evaluate this opportunity.
• Consider future projects that have significant research costs to be US based versus foreign based due to being able to deduct the costs over 5 years vs. 15 years.

Summary of Changes to SRE Expenditures

Accounting Method Change

The TCJA provides that a change to capitalize and amortize instead of immediately expensing SRE expenditures is a change in method of accounting. We should review your current tax treatment of SRE expenditures and understand that those who have historically expensed these costs as incurred need to change their method of accounting for the treatment of SRE expenditures.

Planning for the Change

The option to immediately expense SRE expenditures has historically been an important tool for businesses. Taxpayers must be aware of these rules and prepare to change their treatment of SRE expenditures. Failure to plan ahead may cause a significant tax surprise come April 15th. Following are some things to consider for your future R&E expenses:

Where It Currently Stands

There has been bipartisan support to repeal or defer the changes to Section 174 expensing because it is stifling to innovation, but at the time of this writing no legislation has been enacted into law.

Regardless, now is the time to evaluate the impact of this significant change in the treatment of SRE expenditures. Together we can have a thorough dialogue to create a strategy that works best for you and your business.