R&D Tax Credit and Deductions

What are R&D tax credits and deductions?

Congress has enacted two important incentives for a business to invest in research activities in the United States: the ability to elect to deduct such expenditures currently and the permanent ability to claim a credit for increasing research expenditures.

In 1954, Congress enacted I.R.C. §174 allowing taxpayers, for expenditures incurred after December 31, 1953, to either currently deduct research or experimental expenditures paid or incurred “in connection with” a present or future trade or business, or elect to amortize these costs over a period of not less than five years. Eligible research costs include those paid or incurred for research conducted by the taxpayer as well as research conducted on the taxpayer’s behalf.

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.

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 costs of staffing and supplies that must be incurred 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).

The research credit is calculated, in part, by reference to a taxpayer’s qualified research. To be “qualified research,” the research must meet the following criteria: (1) the expenses must qualify as research or experimental expenditures under I.R.C. §174; (2) the research must be undertaken to discover information that is technological in nature, and the application of which is meant to be useful in developing a new or improved business component of the taxpayer; and (3) substantially all of the research activities must constitute elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality. As such, the rules under I.R.C. §174 are relevant for purposes of I.R.C. §41.

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For which types of research and experimental expenditures are current deductions allowed?

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 deduction is allowed for expenditures incurred in connection with the taxpayer’s trade or business which 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

The current deduction (current expense method) and the deferred expense method are replaced with special capitalization and amortization treatment for expenditures made in tax years beginning after December 31, 2021, as discussed above.

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May a taxpayer both deduct research expenditures and claim the research credit?

No, not for the same expenditures. (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 December 31, 2021.

Subscriber-Only Resource: State-by-State Chart of R&D Tax Credits