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Section 174: Restoring key R&E expenses to drive innovation

Guest March 10, 2024

Startup savvy

It’s rare in today’s political climate to find leaders from both major U.S. parties agreeing on legislation, especially as it relates to taxes and budgets.

But a recent pitch to repeal a long-feared change to the IRS tax code that would prohibit many innovative businesses from deducting key research and experimental (R&E) expenses has actually gained momentum in Washington D.C.—and bipartisan House approval.

The provision in question is IRC Section 174, which historically enabled businesses to deduct R&E expenses ranging from attorney fees to utilities costs. While Section 174 is a separate tax function than the federal government’s banner Section 41 R&D tax credit (more on that here), companies have long relied on both programs to retain liquidity and extend their innovation runway.

We’ll dive into the latest efforts to repeal the Section 174 changes—ideally before the books close on the current fiscal year, when many businesses would have to start paying for the change in procedure.

But first, here’s a brief rundown of how we got here, and what the implications will be if legislators don’t repeal the measures soon.

Key takeaways:

TCJA timer: One important change in the 2017 Tax Cuts and Jobs Act is the requirement for businesses to amortize and capitalize R&E expenses, rather than deducting them in the year they were incurred.
Foreign vs domestic: The amortization period for domestic R&E expenses is five years, while foreign R&E expenses must be amortized over 15 years.
Legislative pushback: While strong opposition to the TCJA's changes to Section 174 has been voiced from both sides of the aisle in Congress, no meaningful revisions have been enacted and the changes took effect in calendar year 2022.
Possible relief on the horizon: H.R. 7024, titled the Tax Relief for American Families and Workers Act of 2024, contains significant changes that would allow business to deduct research and experimentation expenses in the current year.

section-174-temp

A remnant of the 2017 tax cuts and jobs act
Five-year amortization for domestic R&E expenses—For now
Why hasn't section 174 been repealed yet?
What should you expect going forward?
Maximizing access to innovation capital ahead of tax filings

A remnant of the 2017 tax cuts and jobs act

Let’s first rewind to December 2017 and the controversial tax cuts and jobs act (TCJA), which delivered significant restructuring to the U.S. tax code far beyond innovation credits.

While the impacts of the bill were manifold, one key change was that it put a timer on the current definition of R&E under Section 174, which has been in place for more than half a century.

Under the TCJA, qualifying R&E criteria would actually expand beginning in 2022 (or, as the TCJA reads, beginning after December 31 2021). Despite broadening the scope of R&E under Section 174, the TCJA significantly tightened how much companies can use R&E deductions to offset expenses.

As a result, businesses can no longer deduct all R&E expenses during the year incurred, requiring companies to instead amortize and capitalize their annual R&E spend going forward.

The most immediate result for many businesses will be the creation of taxable income—even for some companies that haven’t recorded taxable income previously.

Five-year amortization for domestic R&E expenses—For now

One of the biggest headlines for founders are the new timelines around R&E amortization and capitalization under the TCJA. The revisions also outline separate requirements for R&E amortization based on geography.

For domestic R&E expenses, the amortization period is 5 years, while foreign R&E investments must amortize over 15 years.

Going a step further, expenses are “placed in service” at the midpoint of the first year of amortization, making year-one deductions only roughly half of what they could be in following years.

Another kicker? The TCJA went ahead and redefined how software development costs are treated, mandating that any costs paid or incurred with software development—whether for internal or external use—must be treated as an R&E expense, and thus capitalized starting in the 2022 tax year.

Why hasn’t section 174 been repealed yet?

Despite pressure from business owners, tax attorneys, and even members of Congress from both sides of the aisle, these new amendments to Section 174 plowed right ahead into calendar year 2022 without modification.

What’s perhaps most frustrating for business owners is that the original bill was rife with compromises and language that frankly wasn’t expected to ever go into effect. Despite steady lobbying from lawmakers on all sides to pause or push off the Section 174 changes, lawmakers failed to ever act on any meaningful repeals in the roughly 5 years since the TCJA was put into law.

What should you expect going forward?

Unfortunately, many innovative businesses have already had to face the new tax burden that Section 174 changes bore out in their 2022 filing. While lawmakers may still be able to retroactively allow businesses to leverage R&E deductions for tax year 2022 if new legislation passes, many businesses still saw a double-digit percentage increase in the amount owed in 2022 compared to 2021.

However, there is a bright side for 2023 filings.

As we mentioned earlier, the House recently passed a $78 billion tax bill restoring the ability for businesses to immediately deduct the cost of research and experimentation (R&E) investments for the current tax year.

Along with removing the requirement that domestic R&E investments be deducted over five years, businesses will also be able to immediately deduct 100 percent of their machinery and equipment investments if the new legislation makes it through final approval.

Beyond clarity on R&E deductions, the latest tax legislation also provides interest deductibility for businesses who had no choice but to take out loans at high rates to pay their employees and grow their operations. The bill even takes an international focus, removing the current double taxation that businesses with operations in both Taiwan and the US face today in a bid to bolster competitiveness with China.

If the landmark bill makes it through the Senate and to the President’s desk for signing, all of these measures would run until 2025, reversing many of the most contested pillars of the TCJA.

Maximizing access to innovation capital ahead of tax filings

While the legislation enjoys wide private and public sector support across parties, it’s hardly a sure thing that these changes will be passed in time to impact upcoming tax claims—especially as the IRS has already begun accepting federal income tax returns starting January 29.

There’s still, however, a great opportunity for founders to tap into federal programs to retain their liquidity and stretch their R&D dollars further.

With many businesses now having to claim taxable income either at higher rates or for the first time, the R&D tax credits offered by Section 41 actually become more important and valuable in offsetting dues than they had in the past.

To that end, the R&D tax credit study you compile for your Section 41 claim can be a great starting point to identifying your Section 174 expenditures, as all Section 41 expenses are inherently Section 174 expenses as well.

At Boast, we help innovative businesses identify and quantify all available R&D activities and expenses that can qualify for tax credits to not only minimize the impact on their annual tax bills, but extend their runway in the face of a rocky financing landscape.

To learn more about how teams can build an R&D Capital Strategy that bears in mind the new requirements around Section 174, R&D tax credits in general, and how to plan for the year ahead, talk to an expert on the Boast team today.