Introduction

For companies heavily involved in research and development (R&D), the R&D Tax Credit under Section 41 of the Internal Revenue Code (IRC) is a well-known tool that helps reduce tax liabilities. However, with changes introduced by the Tax Cuts and Jobs Act of 2017, companies also need to be aware of the requirements under Section 174, which now mandates the capitalization and amortization of R&D expenses. Even if your business has conducted an R&D Tax Credit study, a separate Section 174 study is essential. This blog will break down why a Section 174 study is crucial, explain the differences between Section 41 and Section 174, and highlight how TaxTaker can help.

What is Section 174?

Section 174: Historically, IRC Section 174 allowed businesses to deduct their research or experimental (R&E) expenditures in the year they were incurred. Alternatively, businesses could choose to amortize these expenses over a period of at least 60 months. This flexibility provided companies with options to manage their tax liabilities effectively.

However, starting from the tax year 2022, the rules under Section 174 changed. Now, businesses are required to capitalize and amortize R&E expenditures over five years for domestic research (15 years for foreign research). This means that companies can no longer deduct these expenses in the year they occur, which has significant implications for cash flow and financial planning.

Understanding Section 41 (R&D Tax Credit)

Section 41: Section 41 of the IRC focuses on the R&D Tax Credit, which allows businesses to reduce their tax liabilities by claiming qualified research expenses (QREs). These expenses typically include wages paid to employees involved in research activities, costs of supplies used in research, and expenses for developing prototypes or software. The R&D Tax Credit is aimed at encouraging businesses to innovate and develop new products, processes, or technologies.

While Section 41 and Section 174 both deal with research and development expenses, they serve different purposes and have distinct requirements. Section 41 provides a tax credit, which directly reduces the amount of tax a business owes, while Section 174 now mandates the amortization of R&E expenses, impacting how and when these expenses are deducted.

Why a Section 174 Study is Necessary

1. Broader Definition of R&E Expenditures

Section 174 covers a wider range of expenses than Section 41. While the R&D Tax Credit under Section 41 focuses on specific qualifying activities and costs, Section 174 requires the capitalization and amortization of all direct and indirect costs related to R&D activities.

For example, under Section 174, expenses such as rent, utilities, insurance, and employee benefits that are related to R&D projects must also be capitalized and amortized. These costs might not be fully captured in an R&D Tax Credit study, which is why a separate Section 174 study is critical. A Section 174 study ensures that all relevant expenses are identified and properly accounted for, minimizing the risk of non-compliance and financial inaccuracies.

2. Amortization Requirements

The change from immediate expensing to mandatory amortization under Section 174 has significant implications for a company’s tax strategy. Previously, businesses could deduct R&D expenses in the year they were incurred, which provided immediate tax relief. Now, these expenses must be amortized over a period of five years (or 15 years for foreign research), meaning the tax benefits are spread out over time.

This shift can impact a company’s cash flow, as the tax savings are delayed. For example, if a company incurs $1,000,000 in R&D expenses in 2022, under the new rules, only a portion of these expenses can be deducted immediately, with the remainder spread out over the next several years. This delayed deduction can increase taxable income and tax liability in the short term, making it essential to plan ahead.

A Section 174 study helps businesses understand the full impact of these amortization requirements and plan accordingly. Without a proper Section 174 study, companies may understate or overstate their capitalized expenses, leading to compliance issues and potential penalties.

3. Compliance with IRS Regulations

The IRS has strict regulations regarding the capitalization and amortization of R&E expenditures under Section 174. Failing to comply with these regulations can result in penalties, interest charges, or even IRS audits. Given the complexity of these rules, it’s crucial for businesses to ensure that they are accurately documenting and allocating their R&E expenditures.

A Section 174 study provides the necessary documentation and analysis to ensure compliance with IRS regulations. This includes accurately identifying all relevant expenses, calculating the correct amortization schedules, and maintaining proper records. This level of detail is essential for avoiding costly mistakes and ensuring that your business remains compliant with the new tax laws.

4. Impact on Tax Liability

The new amortization rules under Section 174 can significantly affect a company’s tax liability over the next several years. As mentioned earlier, businesses can no longer deduct R&E expenses in the year they are incurred, which can increase taxable income and tax liability in the short term.

For example, if a company generated $500,000 of revenue and incurred $1,000,000 in deductible R&D expenses in 2022, under the old rules, the company would have reported a $500,000 taxable loss. However, under the new Section 174 rules, only $100,000 of R&D expenses (for domestic research) can be deducted immediately, resulting in $400,000 of taxable income. The remaining $900,000 in capitalized R&D expenses will be deducted over the next five years. This change can lead to higher tax liabilities in the short term, which may impact cash flow and financial planning.

A Section 174 study is essential for accurately calculating and planning for these impacts. By understanding the full financial implications of the new amortization rules, businesses can make informed decisions about their tax strategy and better manage their cash flow.

5. Future Legislative Changes

The tax landscape is constantly evolving, and there have been ongoing legislative efforts to reverse or delay the mandatory R&D expense amortization under Section 174. For example, several bills have been introduced in Congress to address these changes, including the Tax Relief for American Families and Workers Act of 2024 and the American Innovation and R&D Competitiveness Act of 2023. While these efforts have not yet resulted in changes to the law, it’s important for businesses to stay informed and be prepared for potential shifts in tax policy.

A Section 174 study positions your business to adapt to any future legislative changes. By conducting a thorough analysis of your R&E expenditures and maintaining detailed records, your company will be better equipped to adjust to any new tax regulations that may be introduced. This proactive approach can help you avoid potential pitfalls and maximize your tax benefits in the long run.

The Benefits of Conducting Both Studies Together

Conducting a Section 174 study alongside your R&D Tax Credit study can provide significant benefits for your business. By integrating these two studies, you can ensure that all relevant expenses are captured and accounted for, maximizing your tax benefits while minimizing the risk of non-compliance.

For example, while the R&D Tax Credit study focuses on identifying and claiming qualified research expenses under Section 41, the Section 174 study ensures that all R&E expenditures are properly capitalized and amortized. By conducting both studies together, you can create a comprehensive tax strategy that addresses both the short-term benefits of the R&D Tax Credit and the long-term implications of the Section 174 amortization requirements.

Additionally, conducting both studies together can streamline the documentation and reporting process. By working with a single provider like TaxTaker, you can ensure that all relevant information is accurately captured and reported, reducing the risk of errors and inconsistencies. This integrated approach can save time, reduce administrative burdens, and provide peace of mind that your business is fully compliant with all applicable tax laws.

Conclusion

Even if your business has already conducted an R&D Tax Credit study, it is critical to undertake a separate Section 174 study. The broader scope of R&E expenditures under Section 174, coupled with the new amortization requirements, necessitates a detailed and accurate analysis to ensure compliance, manage tax liabilities, and optimize your financial strategy. By conducting a Section 174 study, your business can navigate the complexities of the new tax landscape with confidence, avoiding potential pitfalls and maximizing long-term benefits.

TaxTaker is here to help you with both your Section 174 and R&D Tax Credit studies. Our team of experts can guide you through the process, ensuring that you capture all eligible expenses, comply with IRS regulations, and optimize your tax strategy. Contact us today to learn more about how we can support your business and help you make the most of your R&D investments.