Background
The Tax Cuts and Jobs Act, enacted in 2018, included a delayed provision affecting Section 174 research expenses beginning in tax year 2022. Under this change, research expenses could no longer be deducted immediately. Instead, domestic expenses had to be capitalized and amortized over five years, while foreign research expenses were to be capitalized and amortized over fifteen years.
In the four years between 2018 and 2022, there were repeated efforts to repeal or delay this provision, but the provision survived. So, taxpayers with section 174 research expenses began capitalizing them in 2022. Later IRS guidance clarified that these expenses extended beyond those used to calculate the R&D credit. They also encompassed overhead costs and related items, broadening the scope of what must be capitalized.
For many businesses, this meant higher taxable income, reduced cash flow, and a much larger compliance burden than originally anticipated.
Section 174 Relief Overview
The latest legislation provides significant relief in two ways:
- Domestic research expenses are no longer subject to capitalization and may once again be deducted as incurred.
- There are new relief options for the amounts that had to be capitalized in tax years 2022 through 2024.
A few additional items to note:
- Foreign research under Section 174 will still have to be capitalized and amortized over 15 years.
- Software Expenses are still tied to Section 174, meaning any foreign software development will still be capitalized and amortized over 15 years.
- The pre-2022 option to capitalize and amortize over 60 months has been reinstated, but is now a permanent election.
Return of Immediate Deductions for Domestic Research
Beginning with the 2025 tax year, taxpayers will once again be able to deduct domestic research expenses as they are incurred. This restores the long-standing treatment that had been in place for more than 50 years before 2022.
This change provides a welcome level of certainty and stability for manufacturers and other business owners. With immediate deduction, business can now better plan future research investments, budget and strategize without concern of delayed deductions.
Options for Previously Capitalized Expenses
Businesses also have relief options for the research expenses capitalized between 2022 and 2024. All taxpayers have these options:
1. Continue Amortization
Businesses can continue to amortize costs capitalized from 2022-2024 under the existing schedules
2. Accelerate Unamortized Costs Over 1 Year
Conversely, businesses can also opt to accelerate the remaining unamortized costs in one year, the first taxable year beginning after 12/31/2024.
3. Accelerate Unamortized Costs over 2 Years
Finally, businesses can opt to accelerate the remaining unamortized costs ratably over the first two taxable years beginning after 12/31/2024
In addition to the three options available to all taxpayers, eligible small businesses have an additional option:
4. Retroactive Method
Amend tax years 2022 through 2024 to deduct the research expenses. This is known as the retroactive method.
- Please note: Amending the 2022 – 2024 tax returns will also require consideration of the R&D Credit. Before 2022, the R&D Credit was allowed in full if the amount of the credit was also added back into income; there was an option to not add it back into income if a reduced credit was elected. Upon amending these past returns, a decision will have to be made about taking the full credit and adding it back into income or taking the reduced credit. This component, amongst the other options, will have to be analyzed on a client by client basis.
Transition Guidance for Eligible Small Business Taxpayers
For a small business taxpayer that is considering the retroactive method, the IRS provided Transition Guidance for the 2024 Tax Returns on August 28.
- For 2024 tax returns that have yet to be filed: The taxpayer is able to deduct the 2024 174 Research expenses as current deductions.
- If the 2024 tax return has already been filed: The IRS has granted an exception and will treat them as extended tax returns for purposes of having the ability to file a superseded tax return by the extended due date of that tax return. A superseded tax return is a complete replacement of the tax return previously filed. The IRS will treat the superseded tax return as the original tax return. The ability to file a superseded tax return for 2024 eliminates the need for filing an amended tax return.
Once the 2024 return is handled under this guidance, the taxpayer can then move forward with amending 2022 and 2023 returns.
IRS Guidance for Accounting Method Changes & Elections
All of the relief opportunities described require specific accounting method changes and other elections. The details of these elections depend on each taxpayer’s situation and must be handled carefully to ensure compliance. We highly recommend consulting with a tax advisor to implement your chosen approach and avoid any costly mistakes.
Where do we go from here?
The first step is determining whether your business qualifies as an eligible small business under the gross receipts test and tax shelter rules. Your tax advisor can help make this determination.
- If you qualify as an eligible small business, you have multiple options, including the retroactive method. If considering the retroactive method, the timing of the return filings will need to be considered as well as the impacts to the R&D credit, state tax returns, etc.
- If you do not qualify as an eligible small business: The next step is to work through planning and projections to model the options available and determine the timing of accounting method changes and elections.
The path forward will look different for every business. What’s consistent, however, is the importance of planning ahead and modeling the outcomes before making elections. These changes present opportunities as well as potential pitfalls. The Wegner CPAs tax advisors are well-versed in Section 174 approaches and will ensure you choose the option that best supports your business strategy and cash flow needs. Reach out to learn more.
