The passage of the "One Big Beautiful Bill Act" (OBBBA) has revived a key benefit for innovation-driven businesses: the ability to immediately deduct domestic research and experimental (R&E) expenditures under a new Section 174A of the Internal Revenue Code (IRC). This legislative shift is a welcomed relief for companies relying on technological advancement and product development as core business drivers.
With the return of "R&D expensing" comes complex transitional rules and compliance requirements. Working with a knowledgeable tax advisor can help define the strategy moving forward and reduce compliance risk.
Section 174 expensing: Back to business (almost) as usual
Starting with tax years beginning after December 31, 2024, taxpayers will be allowed to fully deduct domestic R&E expenditures in the year paid or incurred. This change, introduced via a new Section 174A, will effectively roll back a major hurdle implemented in 2022 and initially introduced by the Tax Cuts & Jobs Act (TCJA) of 2017.
But not everything is exactly as it was prior to 2022. Businesses engaged in foreign R&D activities will be required to continue the capitalization and amortization of those costs incurred outside of the US. The amortization will remain over a period of 15 years. This treatment, introduced by the TCJA, remains unchanged by the OBBBA legislation. With the return of a favorable treatment of US-based R&E expenditures versus the 15-year amortization of foreign costs, companies may revisit their outsourcing strategy when it comes to product engineering and experimental development.
Furthermore, the OBBBA did not reverse the amendment made by TCJA regarding the treatment of software development expenditures under Section 174. TCJA amended Section 174 to include all software development costs as R&E expenditures. Under the new Section 174A of OBBBA, taxpayers will be allowed to deduct domestic software development costs as R&E expenditures, but foreign software development costs will continue to be capitalized and amortized over 15 years. Taxpayers leveraging software developers outside of the US may want to re-evaluate their strategy considering the much more favorable treatment for software development conducted in the US.
Navigating transitional rules
The transition to the deductibility of R&E expenditures under the new Section 174A will be treated as a taxpayer-initiated change in its accounting method and will be applied on a cut-off basis. In addition to the favorable treatment of R&E expenditures moving forward, OBBBA provides different paths to taxpayers to recover more rapidly the costs capitalized in 2022, 2023 and 2024 under the former version of Section 174. The resulting transition period creates a rare window of strategic flexibility but comes with some uncertainty and technical complexity.
Under the OBBBA, any taxpayer will have the opportunity to elect to deduct unamortized domestic R&E expenditures capitalized in 2022, 2023 and 2024, either in the first taxable year beginning after December 31, 2024, or over two years. For most taxpayers, this means deducting these expenditures either on their 2025 tax return, or ratably over the 2025 and 2026 tax returns. This path is not mandatory, and taxpayers may select to stick to the original amortization schedule for their R&E expenditures from 2022-2024.
Another option will also be available to certain eligible small businesses who will have the opportunity to elect to apply the new Section 174A rules retroactively back to their first taxable year starting after December 31, 2021. To be eligible, taxpayers must have average gross receipts for 2022, 2023 and 2024 of $31M or less. Applying Section 174A retroactively will require that taxpayers amend prior years' tax returns to deduct the R&E expenditures that were originally capitalized.
Adding a layer of complexity to the analysis that taxpayers and their advisors will want to conduct regarding the treatment of prior years' R&E expenditures is the fact that there is currently no administrative guidance available as to how the different elections will be made. Congress directed the Treasury and the IRS to issue procedures, but it is unknown when they will be released. Taxpayers who are currently on extension may want to consult with their tax advisors before filing their 2024 tax returns to review their strategy around the treatment of R&E expenditures and the impact of eventual elections to address previously capitalized costs.
Conforming changes to the R&D tax credit
The OBBBA introduces conforming changes to Section 41 – Credit for increasing research activities, also known as the R&D tax credit, and to Section 280C – Certain expenses for which credits are allowable. Some of these conforming changes go beyond a simple adjustment to refer to the new Section 174A and will have implications for taxpayers claiming the R&D tax credit.
First, the OBBBA amended Section 41(d)(1)(A) which constitutes the first prong of a 4-part test for a taxpayer's activities to be eligible as qualified research. Prior to OBBBA, this section required that expenditures for these activities "may be treated" as R&E expenditures under Section 174. The OBBBA modified this language and now states that expenditures for these activities to constitute qualified research "are treated" as domestic R&E expenditures under the new Section 174A. This new language suggests that taxpayers reporting qualified research expenditures (QREs) on Form 6765 to claim the R&D tax credit may have to continue to report domestic R&E expenditures distinctly despite their immediate deductibility. It could also be problematic for taxpayers claiming the R&D tax credit on amended returns if the costs claimed as QREs were not originally classified as Section 174A domestic R&E expenditures. Reclassification of costs as Section 174A expenditures usually requires a change in accounting method which is generally not allowed on an amended return.
Second, the OBBBA amended the language under Section 280C(c) which dictates how taxpayers claiming the R&D tax credit must either reduce their deduction for R&E expenditures by the amount of credit or elect to claim a reduced credit to keep their full deduction. While detrimental to most taxpayers, the requirement to capitalize R&E expenditures introduced by TCJA had inadvertently eliminated the need for taxpayers to reduce their deduction or their credit. This resulted in a 21% increase in value for R&D tax credits captured in 2022, 2023 and 2024. The OBBBA restored the applicability of Section 280C(c) for tax years starting after December 31, 2024.
It is important to note that eligible small businesses electing to apply Section 174A retroactively by amending prior years' tax returns will also have to comply with these conforming changes retroactively. As such, OBBBA temporarily allows taxpayers to make an election for a reduced credit under Section 280C(c) on an amended return. Such election is generally only available on an original tax return. Eligible small businesses amending 2022, 2023 and 2024 tax returns to deduct Section 174A expenditures will be allowed to elect a reduced credit to avoid a reduction in their deduction. This means however that the R&D tax credits they claimed for those years will be reduced by 21%.
What to do next
The changes introduced by OBBBA have created new opportunities alongside added complexity. For innovation-driven businesses, the path forward will require thoughtful planning and detailed analyses. The impact of the new Section 174A rules and the selection of the strategy to deal with the R&E expenditures capitalized in the past three years should be evaluated systematically and with consideration to other areas of tax planning.
Taxpayers leveraging the R&D tax credit should be fully aware of the interactions between the credit and the treatment of domestic R&E expenditures. The combination of the new Section 174A rules and the recent release of the revised and significantly extended Form 6765 to claim the R&D tax credit will make R&D tax a critical part of year-end tax planning.
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