Section 174 of the Internal Revenue Service code deals with deductions and tax treatment of research & development expenses. This section of the tax code recent underwent several major changes that resulted in less favorable treatment of R&D expenses. Today, we’ll take a close look at the new rules for Section 174, as well as how they’ll affect businesses’ bottom line.
What is Section 174?
Section 174 outlines how to expense R&D expense for tax purposes. Before 2022, businesses could deduct the expenses in the year they incur or amortize them over a period of not less than 60 months.
However, starting in 2022, businesses cannot expense all of their R&D expenses in the year they were incurred. Instead, you must use the amortization method to spread out the cost over five years or 15 years.
Who Qualifies for Section 174?
Any business with R&D expenses is subject to Section 174. Moreover, Section 174 applies regardless of business entity structure so sole proprietorships, partnerships, LLCs, and corporations are all subject to Section 174.
Section 174 also applies regardless of business size. The new legislation will be especially difficult for small businesses that need that deduction (and related tax savings) to continue to invest in their operations. Larger businesses will have more resources to draw on to whether the change in deductions.
What Expenses Qualify for Deduction?
There are several categories of expenses that are subject to Section 174:
Salaries and Wages: You can include the portion of salaries and wages paid to employees engaged in qualified research activities.
Supplies: You can use the cost of supplies from conducting research activities, including any material from creating a prototype.
Contract Research Expenses: If you pay third parties to research on your behalf, these costs might be okay to include.
Research Tools and Instruments: You can consider the cost of tools and instruments for research under this section.
Patent Costs: You can also use the cost of obtaining a patent, such as attorneys’ fees for patent applications, and may deduct.
Note that not all R&D expenses are included in the above. Expenses must relate to the improvement of a product or process using technology to meet the qualifications.
What Expenses Do I Exclude?
Some expenses are excluded from Section 174, including:
Research conducted after commercial production: After you develop a product to the point that it’s ready for commercial sale or use, further expenditures aren’t eligible under Section 174.
Adaptation of existing products or processes: If the research or experimentation simply adapts an existing product or process to a particular customer’s need, it’s not covered.
Survey or Studies: Costs related to efficiency surveys, management studies, consumer surveys, advertising or promotions, and routine data collection are not included.
Quality Control Testing: Regular testing for quality control of existing products is not considered research or experimentation for purposes of Section 174.
Land or Land Improvements: Costs for acquiring or improving land or land improvements are not eligible.
Depletable property: The cost of acquiring or producing depletable property is not eligible.
Certain other activities: Also, you can exclude the following activities from the definition of qualified research: research in the social sciences, arts, or humanities; research funded by any grant, contract, or otherwise by another person (or governmental entity).
What Qualifies as R&D Costs Under Section 174
For expenses to qualify under Section 174, they must meet the following criteria:
Trade or Business Connection: The expenses must incur in connection with your trade or business.
Technical in Nature: The research must be technical in nature, meaning it relies on principles of physical, biological, chemical, or engineering sciences.
Innovation: The activities are for discovering information to develop a new or improved business component. This includes creating new, improved, or technologically advanced products or processes.
Elimination of Uncertainty: The research aims to eliminate uncertainty concerning the development or improvement of a product.
Process of Experimentation: Substantially, all activities involve a process of experimentation, which is an evaluative process that can identify one or more alternatives to achieve a result.
Which States Conform to Section 174?
Each state has its own tax laws and regulations. They can choose to conform or not conform to the federal tax code in whole or in part. Additionally, this means the tax benefits for research and development (R&D) expenses vary from state to state.
Furthermore, some states may adopt the federal provisions of IRC Section 174 in total. Others may have limitations or not adopt the provision at all. For example, some states allow the deduction, but only in the year the expense was paid or incurred. Others require the expenses to be capitalized and deducted over a certain number of years.
Since the most recent update to Section 174, more states are decoupling their rules from the IRS rules and allowing full deductions in the year of expenditure. Likewise, these states include California, Georgia, Tennessee, Wisconsin, and several others.
How Much Can I Save with Section 174?
The amount of money you could potentially save with a Section 174 deduction depends on several factors. Furthermore, this includes the total amount of qualifying R&D expenses, your business’s taxable income, and your tax rate.
Suppose you’re a business owner and spent $500,000 on qualifying R&D costs during the tax year. Under IRC Section 174, you can deduct these expenses from your taxable income.
Likewise, if your company’s taxable income is $2,000,000 and you’re in the 21% corporate tax rate bracket, here’s a simplified example of how you could calculate your potential tax savings:
Without the R&D Expenses:
Taxable income = $2,000,000
Tax liability = $2,000,000 * 21% = $420,000
With $500,000 of R&D expenses:
Adjusted taxable income = $2,000,000 – $100,000 (20% of R&D costs) = $1,900,000
Adjusted tax liability = $1,900,000 * 21% = $399,000
So, by deducting the R&D costs, you could potentially reduce your tax liability by $21,000 ($420,000 – $399,000).
This is a simplified example. The actual calculation may be more complex, considering other tax deductions, credits, and specific tax situations.
Closing Thoughts
The recent changes to Section 174 have limited the deductions to R&D expenses in the year the expense occurred. This will be especially impactful to small businesses, but the rules apply to all entity types and businesses.
It’s important to understand that tax laws are complex. In addition, they subject to change. Lastly, not all states conform to federal provisions in the same manner. Therefore, businesses should seek advice from tax professionals well-versed in federal and state-specific tax laws.