R&D Tax Credits and Deductions

January 26, 2024
R&D Tax Credits and Deductions

The research and development (R&D) tax credit is one of the most significant domestic tax credits remaining under current tax law. Savvy corporate tax teams can use this important tool to implement federal tax planning strategies that maximize their company’s value.

However, the tax issues around R&D investment and acquisitions are not trivial. They are complex, and like many other aspects of corporate tax planning, require forethought and analysis to guide the business in making the right tax-optimized decisions.

What are R&D tax credits and deductions?

Congress created two important incentives for a business to invest in research activities in the United States:

  1. The ability to elect to deduct such expenditures currently (I.R.C. §174)
  2. The permanent ability to claim a credit for increasing research expenditures (I.R.C. §41)

Eligible research costs include those paid or incurred for research conducted by the taxpayer as well as research conducted on the taxpayer’s behalf.

Current deduction or five-year amortization of R&D costs

In 1954, Congress enacted I.R.C. §174, allowing taxpayers, for expenditures incurred after Dec. 31, 1953, to either:

  • Currently deduct research or experimental expenditures paid or incurred “in connection with” a present or future trade or business
  • Elect to amortize R&D costs over a period of not less than five years

The purpose of I.R.C. §174 was to encourage taxpayers to carry on research and experimental expenditures by eliminating the uncertainty concerning the tax treatment of these expenditures. Research and experimentation are basic activities that must precede the development and application to production of new techniques and equipment, as well as the development and manufacture of new products.

Permanent tax credit for increased R&D spending

In 1981, concerned that spending for these activities was not adequate and was in fact declining, Congress enacted a nonrefundable income tax credit for incremental research and experimental expenditures to overcome the reluctance of companies to bear the significant staffing and supply costs to conduct research programs in a trade or business. The credit is incremental in nature to encourage enlarged research efforts by companies that already may be engaged in some research activities. I.R.C. §41 was made a permanent provision of the Internal Revenue Code as part of the Protecting Americans from Tax Hikes Act of 2015 (PATH Act).

What are the new rules for the R&D tax credit?

Due to the corporate tax rate reduction passed as part of the Tax Cuts and Jobs Act of 2017 (TCJA) (i.e., a smaller I.R.C. §280C “haircut” of 21% as opposed to 35%, historically), the benefit of the research credit increased. However, a scheduled tax change that is part of the TCJA will further complicate planning for R&D acquisition and investment, and potentially discourage investment in R&D in the future.

Required R&D cost amortization

Under I.R.C. §174, a current deduction is allowed for research and experimental expenditures paid or incurred in tax years beginning before 2022. The TCJA amended I.R.C. §174 such that, beginning in 2022, firms that invest in R&D are no longer able to currently deduct their R&D expenses. Rather, they must amortize their costs over five years, starting with the midpoint of the taxable year in which the expense is paid or incurred. For costs attributable to research conducted outside the U.S., such costs must be amortized over 15 years. This will be the first time since 1954 that companies will have to amortize their R&D costs, rather than immediately deduct those expenses.

[Download our R&D Notice 2023-63 Overview for guidance on the capitalization and amortization of specified research or experimental expenditures under IRC 174.]

Maximizing R&D tax credit and amortization opportunities

Bloomberg Tax Analyst Benjamin Rubelmann breaks down the new R&D amortization rules and how some research expenses may still qualify for immediate tax credit under §41.

R&D credit limitation

A taxpayer can’t both deduct research costs and claim a research credit for the same expenditure; there is no double tax benefit. Under I.R.C. §280C, a taxpayer must reduce the research expenditure deduction otherwise allowable by the amount of the research credit claimed.

If a taxpayer capitalizes rather than deducts research expenditures, and the research credit for the year exceeds the amount allowable as a deduction for qualified or basic research expenses, then the amount chargeable to the capital account for such expenses must be reduced by the amount of the excess.

However, taxpayers may elect to reduce their research credit instead of reducing their research expenditure deduction or capitalized amount.

As discussed above, no current deduction will be allowed for research or experimental expenditures paid or incurred in tax years beginning after Dec. 31, 2021.

What qualifies for the R&D tax credit?

To qualify for the R&D tax credit, a taxpayer must be engaged in “qualified research.” To be considered qualified research, R&D activities must meet a four-part test:

1. Section 174 test

Research activity expenditures must be eligible for a §174 deduction. Section 174 deductions are allowed for expenditures incurred in connection with the taxpayer’s trade or business that represent research and development costs in the experimental or laboratory sense. These are expenditures for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. The term “product” includes, but is not limited to, any:

  • Pilot model
  • Process
  • Formula
  • Invention
  • Technique
  • Patent or similar property, including the costs associated with obtaining a patent

Expenditures that aren’t deductible research expenditures under §174 aren’t qualified research expenditures.

2. Technological information test

The taxpayer must conduct qualifying research for the purpose of discovering information that is technological in nature, with the intent of applying that information in the development of a new or improved business component. However, the taxpayer isn’t required to succeed in developing a new or improved business component from the discovered information for it to be qualifying research.

A taxpayer may use existing technologies and scientific principles to satisfy this requirement; it’s not necessary that the research be undertaken to expand or refine the common knowledge within a field of science.

3. Process of experimentation test

Qualifying research activities must be part of a process of experimentation for a purpose relating to a new or improved function, performance, or reliability, with the intent that information to be discovered will be useful in the development of a new or improved business component. This experimentation process must be evaluative and generally should be capable of evaluating more than one alternative.

Research related to style, taste, cosmetic, or seasonal design factors is not qualified research.

4. Business component test

The tests for determining whether research is qualified research must be applied separately to each business component. If the tests for determining whether research activity is qualified research aren’t met at the level of the entire product, a “shrinking back” rule applies to the tests at the most significant subset of elements of the product or item for sale, lease, or license. This rule continues until either:

  • A subset of the product satisfies the tests, or
  • The most basic element of the product is reached, and it fails to satisfy the tests

Who is eligible for the R&D tax credit?

Whether or not a taxpayer is engaged in a trade or business for purposes of qualifying for the deduction under I.R.C. §174 is a factual determination. Case law suggests that a taxpayer may establish that research expenditures were made in connection with a trade or business by showing a nontax profit motive and active involvement demonstrated by substantial and regular involvement in the activity.

A good faith intention to make a profit is required, but the expectation of profit need not be reasonable. Courts have held that expenditures of startup enterprises are deductible where the taxpayer demonstrates a realistic prospect of entering a trade or business involving technology. To this end, an objective intent to enter a trade or business and the capability to do so must be shown.

Take advantage of the R&D tax credit with expert insights from Bloomberg Tax

The 2017 TCJA tax changes are further complicating federal tax planning strategies for future R&D acquisition and investment. But the R&D tax credit can be an important part of corporate tax planning strategies to help companies to innovate and remain competitive in the marketplace.

Our Guide to R&D Tax Rules and Analysis provides answers on how practitioners can best apply the latest changes to the R&D Expensing Rules from the IRS and Treasury Dept. For an even deeper dive, download our R&D Overview of §41 and §174 and discover how to maximize your R&D tax credit and amortization opportunities.

Discover all the resources, innovations, and unmatched expertise that only Bloomberg Tax provides, including up-to-the-moment intelligence and expert analysis. Request a demo to learn how Bloomberg Tax helps tax professionals in the technology industry plan today for the realities of tomorrow.

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