Section 174 Expenses and R&D Credits

Research and Experimental (Section 174) Expenditures

The Tax Cuts and Jobs Act of 2017 (TCJA) brought about changes to the tax impact of research and experimental (R&E) expenditures for tax years beginning in 2022.  Taxpayers are no longer able to immediately expense R&E expenditures but instead are required to capitalize and amortize R&E costs related to activities performed within the US over a five-year period.  Costs related to R&E activities performed outside the US have an amortization period of 15 years.  Amortization of all capitalized costs are limited to one-half year of amortization in the first year.

Although there has been considerable bipartisan support to reverse the effects of mandatory Section 174 capitalization, Congress has failed to pass legislation to do so.  The effects of this capitalization on profitable operating businesses can have substantial short-term tax impacts.  The tax effect on start-up companies with tax losses is less severe, but can be tedious to calculate and implement.  Discussions with your tax advisor is suggested.

Research and Development (R&D) Tax Credit under Section 41 of the Internal Revenue Code

Companies developing new or improved products, processes, techniques, software, formulas or inventions may be eligible for an R&D tax credit if they pass a four-part test:

  1. Does the development lead to a new or improved business component?
  2. Is it technological in nature?
  3. Is there uncertainty about the method, approach, or outcome?
  4. Is there a process of experimentation?

To determine the amount of the credit, W-2 wages, materials and supplies consumed in experimentation, contract research expenses, and qualified R&D cloud hosting expenses are considered.

All eligible credits directly offset income taxes (or payroll taxes), so can be advantageous for both profitable operating companies and for start-up businesses who have employees even if they have tax losses.

To be able to claim credits against payroll taxes, a company must meet certain requirements to be considered a qualified small business.  These are:

  • Gross receipts must be less than $5,000,000
  • The taxpayer cannot have had gross receipts for any tax year proceeding the five taxable years ending in the current tax year
  • The payroll tax credit can be claimed for up to five years