Confused About Changes to the R&D Tax Credit? Allow Us to Explain.

Joshua Lee

Changes to the Research and Development (R&D) Tax Credit in 2023 have created setbacks for many businesses nationwide. At a time when more businesses should be taking the credit, the IRS is still promulgating guidance and Congress may change the credit again this year.

That’s why we want to set the record straight, and cut through the noise so more businesses can take advantage of this valuable resource. This post will give you a brief overview of the credit, address its common misconceptions, and act as a guide through the recent legislation and possible outcomes. 

What is the R&D tax credit?

Before we address current events, we thought it would be useful to cover some basics. If you are not familiar with the R&D tax credit, then this serves as an excellent primer, and we invite you to read our deep dive into the credit. If you are familiar with the credit, then this is a great refresher. 

The Research & Development (R&D) Tax Credit is a general business tax credit that was first introduced in 1981. Its aim has been to incentivize companies to perform R&D within the United States. Companies that qualified were able to reduce their tax liabilities by approximately $0.13 cents for every dollar spent. While it was initially intended to be temporary, the R&D tax credit was made permanent over 30 years later in 2015. This has made it a perennial tax planning item that shouldn’t be overlooked.

And yet this is exactly what has happened. 

In 2019, an estimated $60 billion of the $92 billion available R&D tax credits went unclaimed. This was due to two main reasons: 

  1. Lack of awareness. Many companies didn’t know the credit existed or that they may qualify, believing the definition of “research and development” was narrower than it is (more on this in the myths below).
  2. Many didn’t realize there were expanded ways to use the credit when they didn’t have any taxable income. For example, after the Protecting Americans from Tax Hikes (PATH) Act of 2015 was passed, many startups and small-mid size businesses that ordinarily had no income tax could take these credits to offset other types of taxes, primarily payroll taxes. 

Myths around the R&D tax credit

To better understand why the R&D credit continues to be underutilized, we need to first look at the most common misconceptions.

One of the biggest common misconceptions is in the very definition of “research and development.” Most companies believe that research and development only takes place in laboratories with scientists in lab coats, or in actually designated R&D departments. However, the tax definition is much more broad. For the purposes of qualifying for the credit, R&D can refer to work that:

  • Involves technical uncertainty—that is, it’s unclear if or how something can be done, or to determine something where the outcome is unknown;
  • Is technological in nature— The work relies on a hard-hat science (i.e., something you might find in an elementary school textbook like math, computer science, chemistry);
  • Involves a process of experimentation—testing and evaluating alternatives (and the outcome need not be successful!); and
  • Is for a permitted purpose—a new or improved functionality, performance, reliability, or quality.

All this to say, “R&D” can, and does, apply to virtually every industry. 

Changes over the last 5 years

Beginning in the 2023 filing season, a provision in the Tax Cuts and Jobs Act of 2017 (TCJA) impacted Section 174 of the tax code, leaving many companies unclear on how it would affect the tax treatment of research and development (R&D) expenses.

The TCJA stated that starting from the 2022 tax year, companies that deduct R&D expenses would have to be capitalized and amortized over 5 years in the US, whereas previously, they could deduct 100% in the year in which they were incurred. This rule change had significant implications for startups and small businesses conducting R&D — a revenue-generating startup that had been investing significantly in R&D and previously may have owed no income tax now ended up needing to taxes that were consequential for their businesses.

This made claiming the R&D credit more important than ever, but rather than see an increase in tax credit claims, many businesses decided to “wait and see,” hoping that these requirements would be reversed by legislation. That legislation didn’t happen in 2023 as many anticipated, and left many taxpayers, accountants, and observers confused, and, in some cases, not in compliance. 

Recent developments

Early in 2024, a new tax bill—the Tax Relief for American Families and Workers Act—emerged that, if passed, would reverse these changes. However, progress has been slow, and the final outcome is still uncertain.

So while it’s very difficult to predict what will happen, there are a few main potential scenarios:

  1. The bill becomes law before the tax deadlines of March 15th, 2024 (for partnerships and S corporations) or April 15th, 2024 (for C -corporations and sole proprietorships) 
  2. The bill becomes law after the tax deadline of March 15, 2024 (for partnerships and s-corporations) or April 15, 2024 (for c-corporations and sole proprietorships)
  3. The bill doesn’t become law.

We’ll address the implications of these briefly.

The bill becomes law before the tax deadlines

If passed, taxpayers can fully expense US-based R&D costs for the current tax year (2023) through tax year 2025. The requirement to charge US-based R&D expenses to a capital account and amortize it over five years  will be delayed until tax years beginning after December 31, 2025. The requirement to amortize non-US R&E expenditures for fifteen years remains unchanged.

The bill would also impact another tax credit we haven’t yet discussed in this article — the Employee Retention Credit (ERC). The existing deadline to submit claims for the ERC is April 15, 2024, for claims related to 2020 and April 15, 2025, for claims related to 2021. If signed into law the proposed tax package would shorten the deadline to file all ERC claims to January 31, 2024, a date that has clearly already passed. This would not affect already processed ERC claims or the claims already in the IRS backlog, but it would stop the spigot of new retroactive ERC claims.

The bill becomes law after the tax deadlines  

If the bill passes, your business will have the option to fully expense R&D expenditures, which would potentially reduce your income tax liability or, if the company is in a loss position, increase the losses that can be used to offset future income taxes. If you have already filed your tax return you will want to consult with your tax advisor to review how the R&D expenditures were reported on the filed tax return and if they advise filing an amendment to make any adjustments.         

What happens if the bill doesn’t pass?

If the bill doesn’t pass, Section 174 requirements will remain, which means that under current law, U.S. research and experimental expenditures paid or incurred in tax years beginning after December 31, 2021, are required to be amortized over a five-year period. Costs attributable to research or experimentation outside the U.S. must be deducted over a 15-year period.

In conclusion

The outcome of the Tax Relief for American Families and Workers Act could have a significant impact on how your R&D expenses are reported and how the R&D tax credit is utilized. With the March 15th deadline for partnerships and s-corporations and the April 15th deadline for sole proprietorships and c-corporations fast approaching, we recommend you consult with your tax preparer to evaluate your options. If you are not yet profitable, it may make sense to claim your R&D tax credit soon as the bill won’t have as great of an impact on you. If you are profitable, they may advise you to file for an extension.

Joshua Lee is the head of Gusto's Tax Credit team. He spent 13 years at Ernst and Young where he was the lead of the West Coast R&D Credit Team. During his time at EY, he got more involved in the VC scene, where he developed his passion for helping small businesses and startups earn R&D tax credits. He left EY to found Ardius, an R&D tax credit company that Gusto acquired in 2021.
Back to top