The recent failure of H.R. 7024 in the Senate on August 1, 2024, has raised concerns within the professional innovation sector, leaving many companies grappling with uncertainty and financial peril. The bill, which aimed to restore immediate expense deductions for research and development (R&D) activities, fell short of the required 60 votes, ending with a vote of 48 to 44. This legislative inaction comes at a time when economic recession looms, and the consequences are dire, particularly for specialized engineering firms and federal contractors who form the backbone of American innovation.

The Professional Innovation Sector: The Unsung Heroes of R&D

Contrary to the popular belief that R&D is solely the domain of tech giants like Microsoft and Amazon, the professional innovation sector plays a critical role in driving innovation. This sector includes specialized engineering firms, custom machine manufacturers, and federal research contractors, among others. These companies are often the ones developing the cutting-edge technologies that large corporations and government agencies depend on. Historically, these companies have deducted their R&D expenses under Cost of Goods Sold (COGS), a practice that has been accepted by the IRS for decades.

The Tax Cuts and Jobs Act (TCJA) of 2017 marked a significant shift by eliminating the immediate deduction of R&D expenses, mandating their amortization under Section 174. However, this did not alter the long-standing ability to record R&D expenses under other applicable code sections. Despite this, a misguided interpretation has emerged within the accounting industry, unjustifiably asserting that Section 174 now ensnares all R&D expenses. This interpretation, if applied broadly, threatens the very survival of these specialized firms by creating "phantom income"—taxable income based on expenses that have not yet been realized. This could lead to massive tax liabilities that these companies are ill-equipped to handle.

The Immediate Impact: A Sector in Crisis

The professional innovation sector is already feeling the strain. For example, a federal research contractor with $11.5 million in revenue and $10 million in contract expenses might face a $3 million tax bill on "phantom income" due to the forced amortization of R&D expenses. This has led some companies to turn down federal contracts for fear of insolvency. The ripple effects of this could be significant, potentially hindering innovation, reducing GDP, and even threatening national security as key technological developments may be delayed or abandoned.

Uncertain Future: Will There Be a Fix for Section 174?

The failure of the Senate vote has left the future of R&D expensing in limbo. While both Democrats and Republicans have expressed support for restoring immediate R&D deductions, political posturing ahead of the upcoming elections has stalled progress. Democrats have tied the R&D issue to the expansion of the Child Care Tax Credit, a move Republicans oppose due to the associated costs. As a result, any new legislation addressing Section 174 is unlikely to be enacted before the elections, leaving taxpayers in a state of uncertainty well into 2025.

When a new administration takes office in 2025, history suggests it could take 9 to 12 months to assemble a tax package, meaning that businesses may still face the same uncertainty for the 2024 tax year as they did for 2022 and 2023. The potential for a split government in 2025 only complicates matters further, as reaching a consensus on tax reform could prove difficult.

The Possibility of Retroactive Legislation

While there is some hope that any new Section 174 legislation could be retroactive, allowing companies to deduct R&D expenses from 2022 onward, this prospect is growing increasingly uncertain. The longer Congress delays action, the less likely a retroactive fix becomes, leaving businesses in the professional innovation sector with little choice but to plan for the worst.

Self-Help: Reassessing IRC Section 174

Given the uncertainty, businesses must take proactive steps to protect themselves. Understanding the historical context of Section 174 is crucial. Originally passed in 1954, Section 174 was intended to level the playing field for startups, allowing them to deduct R&D expenses just like established companies. This intent was confirmed by the IRS Commissioner during the oral arguments in the 1972 Supreme Court case Snow v. Commissioner. Moreover, the IRS has long allowed businesses to deduct R&D expenses under other sections of the tax code, such as COGS or as ordinary and necessary business expenses.

However, recent Treasury notices (2023-63 and 2024-12) have asserted that these deductions are no longer permitted, a stance that is legally flawed and unsupported by the tax code. These notices have yet to advance into formal regulations, and their future is in doubt, particularly in light of the Supreme Court's recent rulings in Loper Bright v. Raimondo and Relentless, Inc. v. Department of Commerce, which removed the court’s deference to agencies under Chevron. Now, agencies must present the best interpretation of the law and demonstrate consistency in their positions.

What Can Companies Do?

Companies must now distinguish between “Business R&D”, which can still be deducted under traditional methods, and “Investment R&D”, which must be amortized under Section 174. This requires a thorough analysis of their activities and expenses, followed by the preparation of a legal attestation brief to justify their tax treatment. If this seems daunting, businesses should consider hiring a specialty tax consultancy with expertise in R&D tax law to guide them through the process.

In addition to this self-help approach, companies should consider appending a disclosure statement to their federal tax returns, protecting both the taxpayer and the preparer from penalties by clearly stating their compliance with current tax law.

The Role of R&D Tax Credits

Despite the challenges, the R&D tax credit remains intact and can be a valuable tool for businesses, especially those whose R&D expenses are included in COGS. Companies should ensure they are claiming all eligible expenses and preparing detailed project-level reports to meet IRS audit requirements. By doing so, they can strengthen their financial position and continue to drive growth even in these uncertain times.

The Broader Economic Implications

The stakes are high. If the professional innovation sector collapses under the weight of these tax changes, the broader economy will suffer. The loss of these specialized firms would stifle innovation, potentially leading to significant job losses and long-term damage to GDP. Rebuilding this sector would be a lengthy process, further complicated by the potential loss of skilled workers and the disruption of established businesses.

The Path Forward: Advocacy and Adaptation

Beyond self-help measures, it is crucial for business owners and executives to advocate for clearer, more favorable R&D tax laws. Placing pressure on Congress to address the uncertainty surrounding Section 174 and improve the competitiveness of the R&D tax credit with those in Europe and China could help strengthen the U.S. professional innovation sector. This, in turn, would support economic growth and help maintain the country’s position as a leader in global innovation.

In conclusion, while the failure of H.R. 7024 presents challenges for the professional innovation sector, businesses can take steps to navigate this uncertain environment. Through careful analysis, strategic tax planning, and ongoing advocacy, companies can mitigate the impact of these tax changes and continue to play a vital role in the growth and resilience of the U.S. economy.

Author Information

Jenna Tugaoen is a tax attorney at Sycamore Growth Group, an Ohio-based tax advisory firm specializing in assisting businesses to attain and substantiate public economic incentives such as R&D and energy credits.

Rick Kleban is the founder and president of Sycamore Growth Group, an Ohio-based firm specializing in securing economic incentives that maximize cash flow and minimize risk.

James Bean, CPA, is a senior analyst at Sycamore Growth Group, specializing in investigating clients’ tax issues.