What businesses need to know about the recent Research and Development changes

Written by: Leah Belanger, CPA, MSA

The world of tax law is constantly shifting, creating challenges and opportunities for businesses. One recent change that has generated considerable confusion and debate involves alterations to tax incentives for Research and Development (R&D) under Section 174 of the tax code. 

As a refresher, Section 41 provides tax credits for businesses engaged in R&D activities. These credits are typically calculated based on qualifying R&D expenses, such as qualifying wages, qualifying cost of supplies, and qualifying contract research activities. This section remains unchanged and provides significant tax benefits for innovation-centric businesses. 

However, the changes come into play with Section 174, courtesy of the 2017 Tax Cuts and Jobs Act (TCJA). Historically, Section 174 allowed businesses to deduct R&D expenses. This section is now in flux, with potential implications for various companies across diverse industries. 

Effective for the tax year 2022, following a five-year delay, expenses related to R&D are no longer immediately deductible. Instead, they must be capitalized and amortized over a five-year period using what is known as a half-year convention. For example, if a company incurs $1 million in R&D expenses in 2022, it can only deduct 10% in the first year, losing an immediate deduction of $900k. While the remainder is recovered over the next five years, this delayed deduction could significantly impact a company’s immediate cash flow and tax liability. 

Moreover, Section 174 also expands the scope of costs that must be capitalized and amortized, now including ancillary costs related to R&D activities. However, the definition of “ancillary” remains broad, and businesses eagerly await further guidance from the IRS. 

This modification significantly affects not just high-tech industries or pharmaceutical companies but a wide range of businesses. For instance, these changes can impact companies engaged in inventory processing or even orthodontists pioneering new treatments. 

So, what can businesses do? For now, R&D specialists and tax scholars are hopeful that Congress will modify or delay the implementation of Section 174 changes. The TCJA itself sunsets at the end of 2025, and there are ongoing bipartisan efforts to address the issue. However, the new rules are law until any new changes are enacted. 

In the interim, companies should not halt their R&D activities. Instead, they should prepare for these changes by appropriately classifying and tracking their expenditures. A business must follow certain rules even if it does not take the credit. 

We’ll update our information with the most recent changes as we navigate these changes. Stay tuned for updates and remember to consult with a tax professional about how these changes may affect your business.