An Update on Research & Development (R&D)

While it’s no Olympic sport, businesses are met with the challenges of staying relevant among their customer base and sifting out the competition. Meaning, their products or services must be better than those of their competitors – one way to do this is through investing in new products and services or improving existing ones. A company’s research and development activities are enhanced through several tax incentives. As there currently is proposed tax legislation affecting this research expenditure, below we breakdown what business owners should know before they go for the gold:

1. Background on the Research Expenditures

Research expenditures had historically been fully deductible in the year they were incurred. This meant that research expenditures were treated the same as normal operating business expenses from a tax standpoint. Beginning in 2022 under the Tax Cuts and Jobs Act (TCJA), this tax treatment was changed. Research expenditures needed to be capitalized and amortized over five years – 15 years if foreign research was involved. The TCJA also implemented requirements around:

• Software development costs were to be treated as a research expenditure, and thus subject to capitalization and amortization
• In the first year a research expense is incurred, only half of the amortization is allowed

These changes had a significant tax impact on businesses with research activities, as companies were responsible for paying 100% of the research expenses up front but could only deduct 10% of these expenses in the first year. This caused businesses to incur an unexpected tax hit.

2. Proposed Legislation with Research Expenditures

Businesses and tax practitioners alike have lobbied Congress to revert to the prior rules of allowing research expenditure to be currently deductible. As such, the bill presently in Congress, H.R. 7024, Tax Relief for American Families and Workers Act of 2024, would allow research expenditures to once again be fully deductible in the year incurred. It would also include transition relief that would retroactively permit research costs from 2022 and 2023 to be deducted.

This bill passed by a wide margin in the House in January this year; however, it stalled in the Senate. On August 1, 2024, the bill was unexpectedly brought up in the Senate for a key procedural vote to see if it would move forward. The vote failed, and it is unlikely the bill will move forward this year. However, the Senate Majority Leader can bring this bill back up for a vote at any time, and this will need to be monitored closely.

3. Latest IRS Guidance on Research Expenditures

In the meantime, taxpayers must still file tax returns with the rules as they stand now. The IRS has issued guidance to assist taxpayers for their filings beginning with the 2022 tax year.

The IRS issued guidance in IRS Rev Proc 2023-11 to assist taxpayers for their filings starting with the 2022 year. It followed up with expanded guidance in IRS Notice 2023-63, IRS Notice 2024-12, and Rev Proc 2024-9 for the 2023 tax year. The following should be noted from this guidance:

• The IRS indicates more costs should be capitalized for 2023, including some administrative costs. They offer several examples and spreadsheets to follow to capture these costs
• These allocations have the impact of moving a currently deductible cost into a capitalized research expenditure that is amortized over a five-year period
• Many companies will need to file IRS Form 3115 to make the change in accounting method to adopt these rules. This change in accounting method is an “automatic change” but still involves the time/expense of preparing and filing the Form 3115

4. Pending Regulations for Research Expenditures

The IRS indicated it intends to incorporate the guidance issued for 2023 tax returns in Notice 2024-12 into proposed regulations under Section 174 for research expenditures. These regulations will be more extensive in how to identify, calculate and capture the various costs of a taxpayer that need to be treated as research expenditures under Section 174.

The proposed regulations are likely to be issued in 2024, and it is possible they could be released later this summer. This timing would allow taxpayers and practitioners to comment on the proposed regulations, too. There is a chance that the regulations will require taxpayers to review their research expenditures-eligible costs and, subsequently, file another Form 3115 or some other required statement. We will keep you posted on these IRS developments.

5. R&D Tax Credit

The above four topics address the tax treatment for the deduction of research expenditures. However, please note that this does not change the R&D tax credit under Section 41.

Keep in mind that the R&D credit still exists and was not impacted by the TCJA changes or proposed legislation now in Congress. This credit is an opportunity for business owners to capture research costs and realize a sizable tax benefit.  It is an important incentive to aid companies that invest in new and improved products and processes.

Although Congress has made no changes to the R&D tax credit, the IRS continues to regularly audit companies that claim the R&D credit. Businesses are encouraged to thoroughly document their R&D activities and eligible costs and consider obtaining an R&D credit study to support their credit.

It may not be a topic as glamorous as the Olympics, but companies that aren’t familiar with the looming research expenditure changes risk falling behind the competition. Please reach out to your Sikich tax professional if you have any questions related to the tax opportunities with R&D.

About our Authors

Jim Brandenburg, CPA, MST, possesses extensive experience and knowledge in corporate and partnership tax law, mergers and acquisitions, and tax legislation. His expertise includes working with owners of closely held businesses to identify tax planning opportunities and assist them in implementing these strategies.

Larry Johnson, CPA, MST, is a senior tax manager with nearly 40 years of experience closely serving clients with their tax preparation and planning needs. Working with both businesses and tax-exempt organizations, Larry has deep expertise in tax reorganization, consulting and charitable giving/planning.

Tom Bayer, CPA, CExP, has specialized expertise in the areas of business succession planning, tax planning and compliance, and business advisory. He has deep experience providing a range of accounting, tax, and business advisory services to commercial clients across industries.