Section 174 of the Internal Revenue Code (IRC) has historically been a helpful piece of legislation that allows business owners to take tax deductions for research and development costs. However, the Tax Cuts and Jobs Act (TCJA) has changed the landscape significantly.

TCJA transformed the familiar rules of IRC Section 174, starting with tax year 2022. Now, entrepreneurs will no longer be able to deduct all of their research and development (R&D) expenses within the same year that they are incurred.

Other changes include new rules around how software development costs are treated, what counts as qualified research expenses, and more.

If you invest in R&D, whether you’re just starting up or leading a well-established firm, Section 174 could have an impact on your business expense deductions. Understanding this can help you better navigate your tax planning and minimize your tax liabilities.

At the moment, there is pending legislation that could revert Section 174 back for the better. However, its timeline – and chances for success – are unclear.

But don’t worry  – even if Section 174 remains as it is now, we’ve got the information you need to protect yourself during this transition.

Keep on reading to understand what’s coming and what you can do about it.

What is IRC Section 174?

IRC Section 174 refers to U.S. tax law provisions that traditionally allowed businesses to deduct research and development (R&D) expenses. These expenses often involve costs incurred in the development or improvement of a product, service, process, formula, invention, technique, patent, or similar property.

Before recent changes, businesses could either expense (deduct in the current year) these R&D costs or choose to amortize (deduct over a span of time) them over a period of not less than 60 months.

Choosing to deduct R&D expenses in the current year can provide immediate tax benefits and positively affect your cash flow, as it lowers your taxable income. This strategy is often suitable for short-term or one-time research costs.

Alternatively, amortizing R&D expenses over time, spreading out the deduction, might be more beneficial when dealing with extensive, long-term projects. It helps balance finances by matching your cost and revenue over time.

Your choice between the two depends on the nature of your R&D project, its duration, and its potential immediate and long-term financial impacts.

What Do the Changes to Section 174 Mean for Taxpayers?

The changes to IRC Section 174 are significant.

Under the TCJA of 2017, taxpayers must now capitalize and amortize R&D expenditures over a 5-year period starting after December 31, 2021, rather than immediately expensing them. If the research is conducted outside the U.S., the amortization period is 15 years.

This means these costs cannot be fully deducted in the year they are incurred but instead have to be spread out over several years.

Amortize vs. capitalize

So, we defined amortize above. Let’s break down what lawmakers mean by amortize vs. capitalize.

When you “capitalize” an expense, you treat it like an item you own, like a piece of equipment. Instead of saying you spent money on it right away, you spread the cost over several years.

On the other hand, to “amortize” a cost is like slowly paying it off over time. It’s often used for things that aren’t physical, like a patent. Each year, you count a part of its cost as an expense, showing that it’s being used up.

So, “capitalizing” is about spreading out the cost of what you own, while “amortizing” is slowly reducing its value as it gets used.

What type of businesses will be affected?

The changes to IRC Section 174 stand to affect a wide range of businesses, with any organization that incurs research and experimental (AKA R&D) costs feeling the impact. However, those that invest heavily in research and development will feel these changes most significantly.

Take software businesses for example – they’re often in a cycle of continuous investment to develop new programs or enhance existing features.

Similarly, ecommerce businesses investing in website development and optimization will feel the impact of Section 174 changes. Likewise, crypto-based businesses that are exploring new blockchain technologies will also be affected by these changes.

Startups and small businesses will also experience a considerable impact. These businesses often lean on the immediate expensing of R&D costs in their early, income-light years to offset expenses. This practice helps maintain a healthier cash flow to keep operations running.

As far as the type of expenditures included under Section 174, here are the most common ones:

• Labor costs: Salaries and wages for employees who are directly involved in the research process. This can include engineers, scientists, software developers, and other technical staff.
• Materials and supplies: Costs for items used in the research process, such as chemicals for a laboratory, raw materials for product development, or computing hardware for software development.
• Contract research expenses: If you hire a third-party to conduct research on your behalf, these costs might be considered research and experimental expenses.
• Software development costs: Costs incurred in the process of developing new software or enhancing existing software could fall under this category.
• Prototype and model costs: If you’re creating models, mock-ups, or prototypes as part of your research, those costs could be included.
• Overhead costs: Some indirect costs that support research activities, like utilities or rent for a research facility, may also be eligible.

Navigating these changes can be tricky, especially when it comes to taxes. So, we encourage you to consult with a tax professional. They can help make sense of what it all means for your specific situation and guide you on the best way forward.

What does this mean for my financials and tax liability?

The most immediate impact on your financials will be a decrease in your current year deductions, which could lead to higher taxable income and a higher tax bill.

This is because instead of claiming your R&D expenses during the same year they were incurred, Section 174 states that they must be spread out as follows:

• Over a 5-year period for domestic expenditures
• Over a 15-year period for expenditures incurred outside the U.S.

Deferring your R&D expenses means that your year one tax savings may reduce significantly.

For example, let’s say you spent $100,000 in the U.S. on qualifying R&D expenses in 2022. Instead of deducting the full $100,000 amount in 2022, you would deduct $10,000 or $20,000 from 2022 to 2027, depending on the year.

In the initial year (which is 2022 in this example), you can only deduct $10,000. In the next 4 years, you can take a $20,000 deduction (2023-2026). And then in the final year (which would be year 6 or 2027) the deduction would be the remaining $10,000.

Even though we’re amortizing over 5 years, the deduction is actually spread over 6 years.

Additionally, if you’re in the corporate tax bracket of 21%, your savings would change for your 2022 taxes:

• Under the new rules, you’d be able to deduct $20,000 and potentially save $4,200 in taxes (21% of $20,000).
• If you had been able to deduct the full $100,000, you could have saved $21,000 in taxes.

By spreading out the deduction over 5 years, you’d miss out on a tax savings of $16,800 in the first year ($21,000 – $4,200). This can have a substantial impact on companies that heavily invest in R&D.

These new rules will also affect how you prepare your tax returns. For instance, you’ll need to track and categorize your R&D costs differently to account for the new amortization rules.

The above is a simplified example. Depending on your business’s tax bracket, deductions, and other credits, your tax calculation may be more complex. We always recommend getting personalized tax advice a professional.

How Does Section 174 Affect the Research and Development
Tax Credit?

The changes to Section 174 do not directly impact the Research and Development Tax Credit under Section 41, which is a separate provision that provides a tax credit for qualified research expenditures.

The R&D tax credit is a U.S. government incentive that reduces a company’s tax liability for eligible R&D expenses. It’s highly beneficial for businesses investing in innovation, particularly startups and technology-focused companies, as it directly lowers the amount of tax they owe.

So, you can still claim the Research and Development Tax Credit for qualifying research activities, since it’s calculated separately from your R&D expenses under Section 174.

What is a credit against income tax?

Tax credits, unlike deductions, are a dollar-for-dollar reduction of the tax you owe. So, if your business owes $10,000 in taxes and qualifies for a $2,000 tax credit, you only pay $8,000. This makes tax credits like a cash discount on your total tax bill.

What is the difference between tax credits and deductions?

A tax deduction reduces your business’s taxable income, which then reduces the amount of tax you owe. Your accountant typically calculates your taxable income by subtracting eligible expenses (including deductions) from your business’s total revenue. If your total revenue is $10 million and you deduct $5 million in eligible expenses, you will be taxed on only the remaining $5 million.

A tax credit, on the other hand, directly reduces the amount of tax your business owes. So if your total tax bill stands at $1 million and you qualify for a tax credit of $100,000, you would owe a total of $900,000 in taxes.

Let’s look at an example of claiming the R&D Tax Credit

Suppose your software company domestically incurs $1 million in software development expenses, which includes salaries of developers and costs of supplies. These costs could potentially qualify for the R&D Tax Credit.

However, these same software development costs are no longer immediately deductible expenses under Section 174. Instead, they must be spread out over a 5-year period because of the now required amortization deduction.

This change in tax treatment can increase your taxable income in the short term since you’re deducting less in the current year. However, this increased income might also make you eligible for a larger R&D Tax Credit, which is a credit against income tax.

Remember, these are complex issues, and the actual impact will depend on your specific situation. It’s always a good idea to consult with a tax professional who can help you understand how these rules apply to your business’s specific needs.

How Can You Take Action to Fix Section 174? Make Your Voice Heard

It’s crucial that our elected officials understand the impact that these tax changes are having on businesses. You can play a pivotal role in this by reaching out to your congress representative.

Here’s how:

1. Identify your representative: Not sure who represents you? Find your elected officials. By entering your location, you can find out who your federal, state, and local officials are.
2. Craft your message: It’s important to clearly communicate your concerns and what you’d like your representative to do. Here’s a template you can use as a starting point:

Subject: Urgent Request to Advocate for Changes to IRC Section 174

Dear [Representative’s Name],

I am an entrepreneur whose business is significantly impacted by the recent changes to the Internal Revenue Code (IRC) Section 174. This legislation requires the capitalization and amortization of research and experimental expenditures, which is negatively impacting my ability to innovate and grow my business.

I urge you to advocate for a permanent allowance of expenses for Section 174 expenditures. This will encourage innovation and investment in research and development, a cornerstone of our nation’s economic growth.

At the very least, I implore you to support the deferral of the IRC Section 174 amortization requirement for research and experimental expenditures.

It would be greatly beneficial if Congress could retroactively extend the effective date to amounts paid or incurred in tax years beginning after December 31, 2025. This extension would allow businesses like mine to continue expensing R&D costs for a few more years, simplifying tax compliance, and reducing confusion related to cost identification for capitalization versus expensing.

Your attention and support on this matter is greatly appreciated.

Sincerely,
[Your Name]
[Your Contact Information]

3. Follow up: After you’ve sent your message, consider following up with a phone call to your representative’s office. This can help ensure your message is received and understood.

Remember, your representatives are elected to serve you. The American Institute of CPAs has already submitted a letter to congress, urging reconsideration of the treatment of Section 174 research and experimental expenditures.

And your perspective as a business owner and constituent is valuable, and can greatly influence their decisions. Don’t underestimate the impact your voice can have on shaping tax policy.

How Acuity Tax Services Can Help

Navigating the twists and turns of business taxes is no small feat – especially with the recent changes to IRC Section 174, paired with the intricacies of the R&D Tax Credit. The landscape is complex and staying up-to-date, compliant, and tax-efficient can be a daunting task.

But you’re not alone in this journey – Acuity’s tax team is here to help!

We’re ready to extend our support to help you understand and respond to these tax changes.

Our tax team can guide you through the new requirements for capitalizing and amortizing research and experimental expenses, helping you identify eligible costs, and manage the potential impact on your financials and tax liability.

We’ll also help you optimize your R&D Tax Credit claims, ensuring you’re not leaving any value on the table.

Our R&D Tax Credit services help you identify qualified research expenditures, understand how to calculate the credit, and navigate the process of claiming it on your 2022 or 2023 tax returns.