The tax code has long recognized that incentivizing research and development is a critical component of a strong and competitive economy. For nearly 70 years, Section 174 of the tax code allowed businesses to immediately deduct their R&D expenses in the same year those expenses were incurred. American businesses working to develop and improve their products, services and processes were able to lower their taxable income and improve cash flow using R&D deductions. An economic environment that bred innovation was created, which allowed those businesses to create countless new jobs.
Everything changed in 2022 when a provision from the Tax Cuts and Jobs Act took effect that requires businesses to capitalize and amortize their R&D expenses over five years (or 15 years for R&D expenses incurred outside the U.S.). Prior to 2022, a company that earned $5 million in revenue and spent $5 million on research in the U.S. could theoretically eliminate its income tax liability for the year. Under the current rules, that company would only be able to deduct $1 million of its R&D expenses for the year, bringing its taxable income to $4 million.
This provision has already been devastating for many American businesses. It’s increasingly difficult for businesses to justify hiring additional staff while grappling with higher tax bills and cash flow problems. The cost of innovation has simply become too expensive.
Fortunately, newly introduced legislation could reverse the damage and restore tax incentives for forward-focused businesses. Earlier this month, the House Committee on Ways and Means voted to pass the Build It in America Act, part of a larger tax bill proposed by House Republicans called the American Families and Jobs Act. The Build It in America Act includes provisions that would reverse the R&D amortization rule for at least the next four years. The legislation proposes an immediate reinstatement of the original Section 174 rules allowing for same-year deductions on R&D costs. The current proposal would delay the capitalization and amortization rules from going back into effect until January 1, 2026, giving us more time to adopt a permanent correction.
It’s too soon to say whether this proposal will become law, but it is a very promising development for innovative businesses that have been harmed by the updates to Section 174. ARB encourages you to reach out to your legislators immediately to let them know that you support the legislative fix. Contact us about how Section 174 impacts you.
John Hadwen joined ARB in 2021 as a tax director. He specializes in providing individuals and businesses with comprehensive tax compliance and consulting services related to closely-held business, manufacturing, construction & real estate, and professional services firm taxation. Prior to joining ARB, John was a Tax Principal at a large, regional CPA firm.