New Research & Experimental Tax Deduction Guidance, Proposed Legislation by Mark Leaheey, CPA, CGMA, MSA
Posted on June 14, 2024
by
Mark Leaheey
The research and experimental (R&E) tax deduction under Section 174 of the Tax Code has been a boon to U.S. businesses since its introduction in 1954. However, the rules for how taxpayers may claim a benefit for these costs changed in 2022, restricting short-term cash flow. Now, two years later, Congress may have found a fix in new legislation making its way through Congress.
Existing Law
Congress introduced Internal Revenue Code Section 174 to encourage U.S. business innovation and competition by incentivizing taxpayers to invest in developing, designing or improving new or existing products, processes, techniques, formulas or software. Under the law, businesses could fully deduct a broad range of direct and indirect R&E expenditures in the year they incurred or paid for those expenses, yielding an immediate, dollar-for-dollar reduction to their federal tax liabilities.
However, the Tax Cuts and Jobs Act of 2017 changed these rules beginning in tax year 2022 by requiring businesses to instead capitalize domestic specified research or experimental (SRE) expenditures and amortize those costs over five years or 15 years for activities they or their service providers conduct outside the U.S. Without the ability to deduct these costs on a current year basis, businesses have seen an immediate increase in their tax liabilities and, in many cases, an inability to maintain staff and their investments in additional R&E activities going forward, especially in the current inflationary environment.
In 2023, the IRS issued a series of notices clarifying two elements of Section 174 expenses: 1) the treatment of costs paid or incurred by service providers for research performed under contract, also referred to as SRE expenditures, and 2) procedures to automatically change methods of accounting for expenditures paid or incurred after 31 December 2021.
IRS Notice 2024-12 clarified that contracted researchers, including government research facilities, may avoid amortizing R&E expenses and instead write off those costs as a business expense in the current year when they meet the following criteria:
- they bear no financial risks under the terms of the contract with the research recipient and
- they obtain an excluded product right that is separately bargained for and acquired for the limited purpose of performing SRE activities under that contract or another contract with the research percipient.
Researchers contracted to perform R&E (and potential as a result R&D) for third parties therefore should be careful to maintain meticulous records demonstrating that they fall under the excluded product right exception.
Proposed Law
On Jan. 31, 2024, the U.S. House of Representatives passed the Tax Relief for American Families and Workers, which, among other things, would delay the amortization rules for domestic R&E activities until 2026. Foreign research activities would continue to be deductible over 15 years. The law would consequently restore taxpayers’ ability to fully and immediately deduct domestic R&E activities, rather than requiring them to spread out those deductions over five years, and it could do so retroactively to tax years 2022 and 2023. If this is the case and the law passes the Senate, taxpayers could amend their 2022 and 2023 tax returns to claim these expenses immediately.
About the Author: Mark B. Leaheey, CPA, CGMA, MSA, is an associate director of Tax Services with Berkowitz Pollack Brant, where he provides tax consulting and planning services to domestic and foreign businesses in industries that include product manufacturing and processing. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or info@bpbcpa.com.
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