On Jan. 1, 2022, a provision of the Tax Cuts and Jobs Act (TCJA) took effect and altered the treatment of research and experimental (R&E) expenditures under Section 174 of the IRC (Sec. 174 expenses). Historically, businesses have had the option of deducting Sec. 174 expenses in the year incurred or capitalizing and amortizing the costs over five years. But under the new TCJA provision, taxpayers are required to capitalize and amortize these costs over five years for research conducted within the United States or 15 years for research conducted outside of the United States.
Unlike the research and development (R&D) tax credit under IRC Section 41 (Sec. 41), Sec. 174 expenses include both direct and indirect R&D expenses, overhead expenses and all software development costs. Taxpayers may consider conducting an R&D tax credit study as a first step to identify 174 expenses and reduce the negative tax impact of Sec. 174 amortization.
Because Sec. 174 expenses are broader in scope than what’s included in Sec. 41, it’s important that businesses don’t overlook costs that were deductible in previous years. Businesses should review their activities and the relevant departments and cost centers to ensure they’re capitalizing all R&E expenditures. Because the law also requires amortization of foreign research and experimentation expenses, Sec. 174 calculations must also account for the international research activity.
While IRS guidance on R&E expenses is limited, taxpayers should embrace the reality of Sec. 174 capitalization as it stands.