Companies that conduct any R&D need to pay attention to the recent changes in Sect. 174 that could significantly impact how such expenses are valued for tax deductions
The 2017 Tax Cuts & Jobs Act, said to be the most comprehensive changes to tax codes in more than 30 years, included several provisions impacting corporate tax. Although signed into law by then-President Donald J. Trump, several portions of this tax legislation had various timeframes for when they would be rolled out or go into effect.
In 2022, the significant changes to Section 174 went into effect. Enacted in 1954 as part of the Internal Revenue Code (IRC), Section 174 was created to eliminate uncertainty in tax accounting treatment of research and experimental development (R&E, or more popularly, R&D) expenditures and to simply encourage research and developmental experimentation as to way to grow innovation.
Section 174 allows businesses to either deduct or amortize certain R&D costs. Deductions can be made in the year in which they are paid or incurred, or they can be amortized over a period of not less than 60 months, beginning with the month in which the taxpayer first realizes benefits from the expenditures. Below are five things to know now about the updates to Section 174.
1. Which entities are subjected to Section 174 capitalization?
In short, Section 174 applies to any taxpaying entity that incurs qualifying R&D costs independent of specific industry or business size. Specifically, there are several types of businesses that are impacted, including:
- Corporations — Regardless of size, once corporations have incurred qualifying research and development costs;
- Small businesses including startups — Regardless of current profitability status, small businesses and startups that are heavily invested in R&D may capitalize or amortize their research expenses;
- Sole proprietorships, partnerships, and LLCs — Also, these entities can take advantage of Section 174 if they have qualifying R&D expenses; and
- Past-through entities including S-corporations — These too can utilize Section 174 for eligible cost associated with R&D, and the R&D credits can be passed through partners, individual shareholders, or members.
2. What qualifies? What are the kinds of costs subject to Section 174 capitalization?
There are several categories of expenses that can be subject to Section 174 capitalization, including:
- Salaries and wages — The salaries and wages of employees who conducting or directly supervising or supporting research activities can be capitalized;
- Supplies and materials — The cost associated with supplies used in the research process can be capitalized, including anything from lab equipment to the software required for the research;
- Patent costs — The cost associated with obtaining patents for a product or process developed through research activities can be capitalized;
- Overhead expenses — There are certain indirect expenses that can be allocated to research activities, including utilities for a research lab or depreciation on research equipment; and
- Contract research expenses — If a third party is used to conduct the research on a company’s behalf, the cost can be capitalized.
3. What kinds of items are excluded from Section 174 deductions?
Not all R&D expenses can be deducted under Section 174. For example, costs for land or depreciable properties are not deductible. Additionally, costs associated with research conducted after the beginning of commercial production, marketing research, quality control, and funded research (such as research funded by any grant, contract, or otherwise by another person or governmental entity) are generally excluded.
4. What is considered R&D as defined by Section 174?
For tax purposes, the following four-part test from the Internal Revenue Service must be met in order to qualify for R&D credit:
- Business purpose — The research must be intended to benefit a business component, which can be any product, process, computer software, technique, formula, or invention that is to be held for sale, lease, license, or use by the company in a trade or business of the company.
- Technological in nature — The business component’s development must be based on a hard science, such as engineering, physics, chemistry, the life or biological sciences, engineering, or computer sciences.
- Elimination of uncertainty — The activity must be intended to discover information that would eliminate uncertainty about the development or improve of a product or process.
- Process of experimentation — The business must evaluate multiple design alternatives or have employed a systematic trial-and-error approach to overcome the technological uncertainty.
5. Which states have conformity to Section 174?
Companies will have to check with the individual state in which they are filling in to determine if that particular state has conformed. States either conform to the IRC Section on a rolling basis or a static basic. A state that conforms on a rolling basis means it will automatically adopt any changes to the federal tax code as those changes occur. Some states that conform on a rolling basis include Illinois, New Jersey, New York, and Pennsylvania.
States that conform on a static basis adopt the federal tax code as of a specific date and do not automatically incorporate subsequent changes. Some static states include Florida, Georgia, Virginia, and North Carolina. There are some states that have selective conformity (this means they adopt selective portions of the IRC), including Arkansas, Colorado, and Oregon.
It is worthwhile to note that levels of conformity can vary by state and may be subject to specific adjustments, additions, or exceptions based on the individual state’s tax laws.