🔒How the federal Tax Cuts and Jobs Act creates challenges for R&D companies

For 70 years, the Internal Revenue Code (IRC) allowed companies to deduct research and development expenses in the year they were incurred.

The 2017 Tax Cuts and Jobs Act changed that, and it’s been to the detriment of many businesses, especially startups and grant-driven research companies.

Pursuant to the Jobs Act, effective in 2022, IRC Section 174 requires companies to amortize R&D and software development expenses over a period of five years if research is conducted domestically, and 15 years if conducted outside the U.S.

Since the Jobs Act was enacted, it’s been speculated that the 174 amortization requirements would be repealed. It’s been deemed inconsistent with historic tax policy, which always incentivized R&D and innovation.

The Tax Relief for American Families and Workers Act (and the Build Back Better Act before that) not only proposed repealing 174 amortization, but did so retroactive to 2022. The House passed the bill in January 2024, but the Senate struck it down in August.

Amortization schedule

Per Internal Revenue Service guidance, R&D activities are intended to discover information to eliminate uncertainty with respect to the development of a product or process. Software development activities include planning, designing, coding, testing, modifications and enhancements.

Excluded activities under IRC Section 174 include maintenance, training, installation, marketing and customer support.

The pool of 174 costs is quite broad — compensation, facilities, operations, supplies, contractors, even recovery fees (i.e., depreciation) as long as such costs are related to R&D or software development.

The amortization deduction schedule for U.S.-based expenses is 10% in year one; 20% in years two through five; and 10% in year six.

Established companies with smaller R&D budgets are better equipped to weather the storm due to better cash flow and other revenue sources. However, the repercussions for startups and grant-driven research companies can be devastating.

For example, consider the hypothetical company RD-Co, with $1 million in revenue and that spends $1 million on R&D to further innovate. In a pre-2022 tax world, RD-Co’s federal tax bill was $0. Today, RD-Co can deduct only 10% of its $1 million R&D expenses in the first year. Accordingly, $900,000 will be taxed at 21% (assuming a corporation), increasing the tax bill from $0 to $189,000.

This issue is worse if RD-Co is a pass-through entity whose members may be taxable at a higher rate.

Contract research agreements and government grants have been an area of significant debate in relation to 174. A company that receives a government grant to perform research and uses the funds to pay scientists and purchase supplies may have to capitalize and amortize their expenditures as discussed above.

Fee structure, risk and intellectual property rights are all criteria that should be analyzed to understand whether research contract expenses are subject to capitalization and amortization.

State of the state

A handful of states do not follow the amortization requirements of 174.

Assume RD-Co has 100% of its income apportioned to a state that does not follow the federal law to capitalize research costs. Although RD-Co would owe $189,000 in federal income tax pursuant to the example above, it could owe $0 of state tax.

If RD-Co files in states like Connecticut that follow the federal law, it could owe another $90,000 in state income tax.

Tax credits

The bright side is that the R&D tax credit is also available, and some 174 expenses may be eligible for an R&D tax credit at the federal, and possibly state levels.

It’s important to understand the rules and guidance surrounding 174. Not including the correct costs (or ignoring the requirement altogether) can be costly in the future.

IRS audits can occur three years down the road — possibly six if there’s a gross omission on the return; interest and penalties can double the original tax expense.

Bill Claffey is a tax attorney at Glastonbury-based accounting and advisory firm Fiondella, Milone & LaSaracina LLP (FML CPAs).