What is going on with Section 174 and the research expenses?
The uncertain rules around amortizing and capitalizing research expenses are creating significant planning challenges for businesses.
In order to create the illusion that the 2017 tax changes were revenue neutral, Congress eliminated the ability of companies doing research to write off 100% of their costs in the year they were incurred. Instead, they must amortize most of the costs over that year and the next five years (or in a small number of cases 15 years) in a complicated formula that allows for only 10% of costs to be deducted the year they are incurred.
For many businesses, this undermined the incentive to invest in research and innovation, which is the purpose of the R&D Tax Credit and Section 174 in the first place. Research has shown that businesses are more apt to invest in R&D because of the lucrative tax savings.
A broader swath of research expenses are allowed under Section 174 than under the R&D Tax Credit. For example, the Qualified Research Expenses under the R&D Tax Credit are limited to wages, but under Section 174 they may include nontaxable benefits and retirement contributions.
As part of the 2017 law, implementation of this change was postponed until 2022. With bipartisan support for reinstating full deductibility, all parties expected the amortization requirement to be eliminated by then. That hasn’t happened because lawmakers have not been able to agree on exactly how full deductibility should be restored.
Where does that leave your business for Tax Year 2025?
How can you plan whether and how much to invest in innovation when you don’t know what the tax implications will be? For a company investing $1 million in R&D, the difference between earning a tax credit for $1 million and being able to write off just $100,000 this year is gargantuan.
From 2022 to 2024, businesses were resigned to amortizing their research costs under Section 174 and capturing smaller upfront tax offsets. But this year, the majority in Congress has made tax cuts a priority, raising expectations that the unpopular changes from the last tax law changes will be eliminated or postponed to some later year.
Read more: How Sec 174 Impacts R&D Companies’ Taxable Income
Is relief from the Section 174 amortization rules on the horizon?
No one knows for sure about the shape of this year’s tax cut package, much less the single provision governing the deductibility of research expenses. Despite widespread support for eliminating amortization, any bill must navigate the tricky road to earning a majority of votes in two divided houses of Congress and the support of the President.
For now, your business should be planning as if they must continue amortizing their tax savings. If Congress fails to overturn the amortization and capitalization requirement for Section 174 expenses, you are prepared for the resulting tax impact. If the law is changed, and takes effect for this tax year, your company will receive a windfall. Remember that there is a third possibility: elimination of the amortization requirement could be part of the new tax law but not take effect until a later date.
The bottom line is that businesses with research and development expenses need to seek guidance from tax experts with experience handling all the many complex provisions and limitations of Section 174, and can guide their clients to making the best decisions and avoiding trouble with the IRS.
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