Section 174 Costs Capitalization and the R&D Credit

Research and development is an important part of the business process. To stay competitive, a business must think about its future product lines and how to keep new products in the pipeline. The research and development stage is capital intensive, but the result will not be realized until some date in the future. The IRS recently released Notice 2024-12 addressing Section 174 costs capitalization, which modifies the treatment of research expenses. Here’s what you need to know.

What is Section 174?

IRS Section 174 was first enacted in 1954. It recognizes that research and development expenses are a necessary cost for businesses to stay competitive. The spirit of the law is to encourage innovation and allow companies to remain competitive.

Before 2022, expenses associated with research and development could be deducted in the tax year they incurred. The business could choose to take the deduction all at once, or amortize the expenses over a 60-month period that began in the first month they benefited from the research.

In 2017, the Tax Cuts & Jobs Act (TCJA) was signed into law by President Donald J. Trump. This modification eliminated the choice of how Research and Experimentation (R&E) expenses were treated. The company no longer had a choice regarding how these expenses were treated. Companies were required to amortize them. This went into effect on December 31, 2021.

The latest changes would revert Section 174 to its previous state and allow companies to once again have a choice of how they recover expenses associated with research and experimentation. This revision is effective retroactively beginning after December 31, 2021. This is good news for businesses because they can choose how to treat these deductions. It would also expand the credit to new and small businesses.

What is Section 174 Costs Capitalization?

Cost capitalization means that an expense is not recognized in the actual period when it occurred. Instead, the expense is spread out over time. This allows you to spread the deduction for the expense over time in smaller chunks, rather than taking a big deduction at once.

The advantage of capitalization is that the company is expected to see some return on the investment during that time, which helps to offset the initial costs. Capitalization applies to fixed assets, such as the purchase of equipment or a required service. Section 174 allows businesses to treat the costs of research and experimentation in such a way.

How Does Sect. 174 Impact The R&D Credit?

Section 174 allows corporations, small businesses and startups, sole proprietorships, LLCs, and some S-corporations to deduct costs associated with new product development. These include expenses such as salaries, supplies, patent costs, overhead, and contract expenses. It also has several exclusions that might affect a business entity.

What Activities Could Be Impacted by the New Sect. 174?

The following list is an example of the general categories of research-related expenses that can be deducted under the new regulations. The current revision to Section 174 lets you choose how you deduct these expenses.

Direct Conduct

Direct conduct is any expense associated with engaging in the process of research. This research might be a new process, technique, software, invention, or formula for improving a product or introducing a new one to the market. This can include things such as writing code or developing an algorithm for a process. It includes building or testing prototypes for a new product or piece of machinery, or it might be developing a new method for manufacturing a product.

Direct Supervision

Section 174 also lets you deduct costs associated with the supervision of the research activities. Supervision is important for keeping the project in alignment with the goals and objectives. The supervisor must often perform managerial duties, such as tracking progress and milestones. It can also involve coordinating various entities during the process and providing guidance to teams.

Direct Support

Costs associated with direct support of the project can also be deducted. This might include activities that do not directly move the project forward, but it can include activities such as maintaining equipment, analyzing data, or documentation. It can include compliance documentation and defect management during the research phases.

Other Indirect Costs

You can also deduct some indirect expenses, such as employee overhead. This can include benefits like payroll taxes, retirement plan contributions, vacation pay, uniform costs, and sick pay. IRS Rev. Proc. 2023-8 provides further clarification on types of indirect expenses that can be deducted.

One thing to keep in mind is that Section 174 also has several exclusions. For instance, costs for land or depreciable properties cannot be deducted. Also, you cannot deduct costs associated with research that occurs after commercial production has begun. For instance, you cannot deduct ongoing market research or quality control expenses. In general, any expenses covered by another entity through a grant or other funding source cannot be deducted.

Key Takeaways for Businesses Claiming the R&D Credit

Here are the key takeaways for claiming an R&D credit under the new revisions.

Closing Thoughts on Section 174 Costs Capitalization

For many businesses, these new changes will result in a lower federal tax benefit because they will not be able to deduct them at the corporate tax rate of 21%. Using the R&D tax credit available under Section 41 can greatly reduce the loss of these deductions. If companies choose not to claim this credit, they can expect to have a higher tax liability. The Section 174 changes will have a significant impact on tax liability for your business, and it is important to understand them before filing your taxes this year.

Our Tax Hack pros can help you get the most out of the R&D tax credit with customized strategies and guidance. Connect with a tax pro today for a one-on-one strategy session, or take our R&D Assessment Survey, to see how much you can save.

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