R&D Deduction Update

By Martin E. Prendergast, MBA
Gray, Gray & Gray, LLP

The U.S. tax code offers various provisions designed to incentivize business growth and innovation. Among them, Section 174 plays a crucial role by allowing businesses – including many in the architecture, engineering, design, and construction industries – the option to deduct or amortize research and experimental (R&E) expenses (also known as R&D expenses). This provision has been instrumental in fostering innovation across various sectors and contributing to the country’s economic prosperity. However, changes to Section 174 effective 1/1/22 have suspended the ability to immediately deduct research and experimental expenditures in the year the expenses are incurred. This major tax law change has generated uncertainty, cash flow crunches and surprise tax bills for businesses heavily reliant on R&E investments.

Briefly, Section 174 of the Internal Revenue Code (IRC) applies to any business incurring qualified R&E expenses. These expenses span everything from wages paid to researchers to the cost of materials and equipment used in a very wide range of R&E activities. Previously, businesses had the option to deduct all qualified R&E expenses in the year they are incurred. This immediate deduction provided significant tax savings and boosted cash flow, particularly for startups and businesses with high upfront R&E costs.

Alternately, companies could amortize qualified R&E expenses over a period of not less than 60 months. This option allowed businesses to spread the deduction over multiple years, potentially reducing their taxable income more evenly over time. 

However, the Tax Cuts and Jobs Act of 2017 (TCJA) significantly overhauled the U.S. tax code and temporarily suspended Section 174’s immediate deduction option for R&E expenses. Everything currently must be amortized over at least 5 years (15 years for expenses incurred outside the U.S.).This suspension was primarily motivated by a desire to raise revenue and offset the cost of other tax cuts implemented under the TCJA.

The TCJA also modified the bonus depreciation rate on qualified depreciable assets or property, phasing it out by reducing it 20% per year, from 100% depreciation in 2022 to 0% by 2027.

The suspension was met with criticism from various stakeholders, including businesses, researchers, and economists, and numerous bipartisan proposals have been introduced in Congress advocating for the reinstatement of the immediate deduction for R&E expenses and bonus depreciation, as well as restoring certain business interest deductions that had been cut. As recently as late November 2023 a group of House Republicans were urging action on a bill to restore all three of the TCJA cuts. There is hope that we may see action, but not immediately.

The consensus best chance to pass a bill restoring the immediate R&E expense deduction option under Section 174 is to add it as an amendment to another spending bill or as an “extender.” However, with the recent passage of a temporary government funding package, which did not address Section 174, there is little chance proponents of restoring the deduction will be able to find another bill on which to “hitch a ride” this calendar year. The next milestone appears to be January 19, 2024, and February 2, 2024 when the House and Senate must pass a dozen or so government funding bills for fiscal year 2024 and satisfy the continuing resolution that kicked the government shutdown “crisis” down the road from November 2023 until January and February 2024.

What should you do? Gray, Gray & Gray is generally advising clients to take a wait and see approach, while planning for the worst-case scenarios now when paying estimated tax payments on behalf of tax year 2023. In addition, we suggest focusing on 2023 tax planning strategies and pulling all other practical tax saving levers within business taxpayer’s control.  

As of now it appears highly unlikely a bill will be passed to retroactively restore the immediate Section 174 expense deductions for R&E costs back to 1/1/22 impacting the 2022 tax years that have already been filed. The “best-case scenario” based on the current pieces of legislation circulating through the House and the Senate seek to restore the immediate deductibility of R&D expenses effective for tax years 1/1/23 forward; meaning any R&E costs capitalized for 2022 would be slowly amortized back in as deductible expenses from 2022 through 2027, while no future capitalization of R&E expenses for 2023 forward would be required. There is extensive support on both sides of the aisle in D.C. to repeal these unfavorable tax law changes, however, the current dysfunction in Washington presents the biggest obstacle to taxpayers across the nation finding relief.