How To Handle the Changes to R&E Tax Treatment

Kirsch CPA Group

Nov 05, 2024

The Tax Cuts and Jobs Act (TCJA) included a significant — but delayed — change to the tax treatment of research and experimentation (R&E) expenses under Internal Revenue Code (IRC) Section 174. To the surprise of many experts, Congress failed to act before the change took effect in 2022, and manufacturers have been feeling its effects ever since.

The National Association of Manufacturers (NAM) continues to sound the alarm about the adverse effects this change has had on its members, particularly small and medium-sized manufacturers. Let’s take a closer look at the new tax treatment, how it’s played out and how you potentially can mitigate the negative tax consequences on your bottom line.

The New Approach

Before the TCJA provision went into effect in 2022, a business that incurred R&E costs could either deduct them in the year they were incurred or capitalize and amortize them over a minimum of five years. Software development costs could be expensed immediately, amortized over five years from the date of completion or amortized over three years from the date placed in service.

Now, specified R&E expenses — meaning those paid or incurred during the tax year — can’t be deducted. Instead, manufacturers must amortize those expenses over five years if incurred in the United States or 15 years if incurred outside the country. In addition, software costs are treated as Sec. 174 expenses, subject to the same requirement.

When the amortization requirement was implemented, many manufacturers found themselves shouldering far greater tax bills than they’d come to expect. Some even ended up with taxable income despite having had a loss year. The higher tax bills have undermined liquidity and forced some manufacturers to lay off workers or seek financing.

The NAM has highlighted the disparity between the U.S. tax policy for R&E and that of other countries. China, for example, generally allows a deduction equal to 200% of eligible research expenses. While China generously rewards innovation, the U.S. policy may inadvertently deter research here.

Steps To Mitigate the Impact

Although current tax law requires amortization of all R&E expenses, manufacturers have tools for easing the financial pain. Have you been claiming the research tax credit under IRC Sec. 41, commonly referred to as the “research and development” or “R&D” credit? If not, determine whether you have eligible expenditures.

Manufacturers sometimes overlook the research credit because they don’t think they’ll qualify. But the credit isn’t limited to technology or other innovation-based businesses. If you develop new manufacturing processes, products or techniques, you may qualify for this lucrative — and refundable — credit.

The research credit is generally equal to 20% of the excess of your qualified research expenses (wages, supplies and contract research expenses) for the taxable year over the base amount, plus 20% of your basic research payments. It’s worth exploring both past and current eligibility, especially as more manufacturers are looking at ways to incorporate artificial intelligence into their operations. (Note that Sec. 174 applies regardless of whether you claim the research credit.)

You also could offset some of the impact of Sec. 174 amortization by leveraging accelerated depreciation. For example, if you’re depreciating all of your commercial property over a 39-year recovery period, a cost segregation study might be in order.

The study can identify the different component assets according to their recovery periods (five, seven, 15 or 39 years). Even if property was placed into service years ago, it may be possible to now claim depreciation that you were entitled to claim in previous tax years. And some components could qualify for first-year bonus depreciation.

Similarly, it might prove worthwhile to check the recovery periods of the items in your fixed asset ledger. You may be depreciating assets with shorter recovery periods over the 39-year period for real property.

Finally, it can pay off to also re-examine your R&E expenditures. If you can properly reclassify any as Sec. 162 business expenses, you may immediately deduct them, rather than amortizing.

An Uncertain Future

In a 357-70 vote earlier this year, the U.S. House of Representatives passed a tax measure that would temporarily restore the previous immediate expensing option. The Senate, however, blocked the bill (because it also included an enhanced Child Tax Credit).

Congress is expected to take up tax legislation in 2025, regardless of the election outcome, because many significant TCJA provisions are scheduled to expire after 2025. Stay tuned to see if any resulting legislation includes a Sec. 174 fix.

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