Big news: The way businesses deduct R&D expenses is changing again, which presents a special opportunity. We dive into the details below, so keep reading.
Recent changes for businesses doing Research and Development (R&D)
The recent One Beautiful Bill Act (also known as H.R.1) changed how companies can treat their research and development expenses, bringing back the ability to deduct them immediately. Additionally, small businesses can apply this change to past years, presenting a unique opportunity.
The R&D tax credit remains a valuable tool for reducing business tax burdens, and the change to Section 174 makes it even more valuable. Let’s go through the change step by step—and review what it means for your business.
What is Section 174?
Section 174 addresses how businesses account for the costs of R&D. It covers R&D expenses for discovering new information in developing or improving a product or process. This includes salaries, supplies, and fees for outside contractors researching on your behalf.
How has the Section 174 treatment changed?
Before Tax Year 2022: Businesses had a choice: either deduct all their R&D expenses in the year they were spent or spread them out over at least five years. Software development costs also have flexible options. Most businesses chose to deduct them immediately, which was great for reducing their immediate tax bill.
For Tax years 2022-2024: Businesses could no longer deduct all R&D expenses in the year they incurred them. Instead, businesses were required to spread them out (amortize them) over:
Five years for R&D done in the U.S.
15 years for R&D done outside the U.S.
This affected cash flow because businesses could only deduct a small portion of R&D costs in the first year (10% for domestic R&D), often resulting in higher taxable income, a higher tax bill, and, therefore, less cash.
Starting in Tax Year 2025: The new bill allows businesses to once again immediately deduct domestic R&D expenses in the year they are incurred. They may also elect to spread them out over at least five years. Expenses incurred outside of the U.S. must still be spread out over 15 years. Companies that incurred and amortized expenses may immediately deduct any unamortized amounts on the following year’s return.
Small businesses (with less than $31 million in gross receipts) may retroactively deduct R&D expenses on their 2022 through 2024 tax returns.
How does this change the R&D Credit?
The R&D tax credit does not fundamentally change under the new legislation. Instead, the new bill makes it more appealing for businesses to invest in research and development by allowing for immediate deduction of related expenses since all expenses used to calculate the R&D tax credit are also expenses for purposes of 174.
Small businesses (< $31 million in gross receipts) may amend their prior returns to claim the credit and immediately deduct the associated expenses. However, the clock is ticking on this opportunity. Many small businesses will only have until their 2025 filing deadline (March or April 15th, 2026) to amend the 2022 return due to the statute of limitations on amended returns. Others will only have a year from the enactment of the new legislation to amend due to time limits placed on related tax elections.
What are examples of activities that fall under Section 174?
Direct Conduct: Direct conduct of qualified research involves actively engaging in the process of experimentation or technological inquiry aimed at achieving a new or improved product, process, software, technique, formula, or invention.
Example activities:
Performing experiments to develop a new chemical compound with specific properties
Writing code to create a more efficient algorithm for data processing
Building and testing prototypes for a novel piece of machinery
Example documents:
Technical specifications
Source code
Conceptual documents
Proposed product or prototypes
Feasibility analysis
System design documents
Direct Supervision: Direct supervision involves overseeing and managing research activities to ensure they align with the goals and objectives of the qualified research. It involves providing guidance, making informed decisions, and ensuring adherence to established protocols.
Example activities:
Managing tasks, milestones, and tracking progress in a research project
Overseeing a team of researchers, providing guidance on methodology, and ensuring adherence to safety protocols
Coordinating efforts between different teams involved in a complex R&D project
Example documents:
Project charter
Coding standards
Business case
Backlog management
Architectural designs
Direct Support: Direct support refers to the activities that assist, facilitate, or contribute to the progress and success of qualified research without directly engaging in experimentation. This includes providing resources, expertise, or specialized services.
Example activities:
Preparation and maintenance of equipment for researchers conducting experiments
Processing and analyzing data generated from experiments to derive meaningful insights
Technical documentation of the research process, outcomes, and findings for future reference and compliance documentation
Example documents:
Unit and integration tests
Automated test suites
Defect management
Technical documentatio
Is it worth amending prior-year tax returns to qualify for the R&D tax credit?
The decision of whether to amend prior year tax returns varies from business to business, depending on your unique circumstances.
It’s best to talk to a tax professional about whether or not amending tax returns is right for you. If you move forward with amending a prior year tax return and filing for the R&D tax credit, Gusto is here to help.
Still have questions about Section 174?
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