The IRS has strict guidelines about how your business must treat specified research and experimental (R&E) expenditures, under Section 174 of the Internal Revenue Code. Amendments were made to the rules at the end of 2024. To comply with the new capitalization and amortization requirements, your company may need to adjust its accounting methods.
In this blog, we’ll cover everything you need to know about the amortization of R&E expenses, and how the recent changes to the process can affect your business.
Overview of the New R&E Cost Amortization
If you’re wondering about the reason for changes to how R&E expenses are handled, look no further than the Tax Cuts and Jobs Act (TCJA) of 2017. Previously, your business could immediately deduct R&E costs in the year they were incurred, for immediate tax benefits. Alternatively, you could capitalize and amortize the expenditures over a period of at least 60 months.
But now, the option for immediate expense is off the table. Instead, your company must capitalize and amortize R&E expenses over a specified period. For domestic costs, you have five years, and you’ll get 15 years to do the same with foreign R&E expenditure. Importantly, these periods start at the midpoint of the tax year in which you pay or incur the costs.
While this process is not exactly new, the IRS’ recent guidelines provide additional guidance and clarification. For starters, it affects all R&E expenses from December 31, 2021. So it’s essential to ensure that your business is compliant.
What Counts as R&E Under the New Rules?
In a nutshell, qualifying R&E expenses are those your business incurs for trade, experimental research, and development costs. In other words, this includes costs for discovering information for the development or improvement of your products or services. Note that ‘products’ here include techniques, formulas, processes, inventions, or intellectual property. It also includes expenses connected to software development.
For a practical example, the following are qualifying expenses:
- Staff compensation: Wages and salaries paid to employees directly involved in research activities.
- Supplies: Costs of the materials and supplies used when conducting research, including payments to third parties for conducting research on your behalf.
- Software development costs: Expenses associated with software development, even if the software is intended for internal use or sale.
If you have operational costs that don’t qualify as R&E expenses, they must be expensed immediately. This includes buying or improving land and depreciable property, as well as costs associated with quality control and efficiency studies.
Because of this, you’ll need to carefully assess whether your costs actually qualify as R&E in order to ensure compliance. If you’re in any doubt, it’s best to consult with a tax professional.
Implications for Innovation-Driven Industries
The change from immediate expensing to amortization of R&E expenses over several years has significant implications for innovation-driven industries. Specifically, this can impact businesses in sectors like technology, pharmaceuticals, or biotech.
After all, under these new rules, R&E expenses can no longer be deducted in the year they’re incurred. This could increase your taxable income in the short term, affecting your cash flow and potentially increasing your upfront costs. It might even influence how your business allocates resources and funds to projects.
Moreover, because such expenses must now be amortized over five or 15 years, depending on where they were incurred, you need to factor them into your long-term financial planning. This can affect your financial planning and investment strategies.
Tax credits and incentives
It’s important to note that these changes to R&E expenses don’t affect whether you can claim the Research and Development (R&D) tax credit. Remember that all R&D credit expenses qualify as R&E expenses under Section 174. So you can still make use of federal and state R&D credits, for a dollar-for-dollar reduction in your business’ tax liability.
Best Practices for Compliance and Strategic R&E Planning
So how do you ensure that your business complies with the changes to the amortization of R&E expenses? The solution is strategic management. This means:
- Accurate cost tracking and allocation: Keep detailed records of R&E expenses. Your finance team will need to accurately distinguish between qualifying expenditures and other operational costs.
- Effective amortization schedules: Speak to a tax pro about establishing compliant amortization schedules tailored to your company’s R&E activities. This should include annual reviews to accommodate any changes in your spending, or additional regulatory updates.
- Stay up to date on IRS rules: As we’ve seen, the IRS can make changes to tax laws and processes at any time. Staying informed about potential modifications will help you remain compliant, and tailor your financial strategy to make the most of any changes.
If you’re still in doubt about handling R&E expenses, or need help with your business taxes, schedule a Discovery Call with one of our tax experts today!
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.