In late January, the U.S. House of Representatives passed a bill to "fix" Section 174 of the Internal Revenue Code, which addresses the taxation of research and experimentation (R&E) expenses. Unfortunately, the bill stalled in the Senate, and it is unlikely that Congress will revisit it before the elections. As a result, taxpayers and their CPAs must now decide how to handle R&D expenses on their 2023 tax returns.

The Problem: Impact of the Tax Cuts and Jobs Act on Section 174

The Tax Cuts and Jobs Act (TCJA) of 2017 introduced significant changes to expenses recorded under Section 174. Previously, R&D expenses could be immediately deducted. Now, they must be amortized over at least five years. This change materially impacts taxpayers engaged in customer engineering projects as they almost always include R&D activities. Traditionally recorded in their cost of goods sold (COGS), recording, and thereby amortizing, these expenses under Section 174 will result in "phantom income," increasing taxable income without a corresponding rise in cash flow.

In 2022, many taxpayers had the cash to cover the extra tax, but most no longer have sufficient funds in 2023. For instance, an engineering company with $10 million in revenue, a 10% net profit margin, and $4 million in eligible R&D expenses would face a $3.6 million reduction in current-year expenses. For a C-corporation, this results in an additional $720,000 in taxes. For a pass-through entity at a 37% marginal tax bracket, the extra tax burden would be $1.3 million. Consequently, businesses must choose between maintaining cash flow or paying the additional tax.

Lack of Diligent Analysis

Despite the extensive commentary on the TCJA's Section 174 amendment over the past three years, diligent analyses remain scarce. Most articles repeat conclusions from large firms without deep investigation. There are understandable reasons why this issue is under-examined.

First, this issue affects only a subset of tax firms’ clients. Second, the industry is short-staffed and recovering from the increased workload of new COVID-19 programs and their clients' economic challenges. These factors left the industry with little time or energy to spare. Lastly, there was a widespread expectation that Congress would fix the R&D tax law, a hope that has yet to materialize.

Unexamined Assumption

A prevailing assumption is that Section 174 overrides all other tax code sections. However, if this were the case, why have businesses recorded R&D expenses in COGS or as ordinary business expenses under Section 162 for the past forty years? Were these longstanding practices incorrect? If not, how did the TCJA change this?

The Section 41 "May" Clause

Section 41(d)(1)(A) specifies that expenses eligible for the R&D tax credit are those that "may be treated as specified research or experimental expenditures under section 174." The TCJA’s use of "may" demonstrates the authors affirmed that expenses meeting the R&E definition can be recorded under other code sections, contradicting the idea that Section 174 overrides all others.

IRS Historical Practice

The IRS has historically allowed legitimate R&D expenses to be recorded in COGS. Treasury Regulation 1.471-11(c)(2)(ii) supports this by indicating that R&E expenses may be included in inventory, thereby COGS. Thus, the IRS has long accepted that R&D expenses can be recorded under other code sections.

Did TCJA Change the Interplay Between 174 and Section 471 Costs of Goods Sold?

No. The TCJA modified Section 174 by removing the immediate deductibility of research and experimentation costs under this code section, requiring amortization instead. However, when the TCJA amended Section 41, it preserved the "may" clause, indicating that the historical interplay between Section 174 and other sections like COGS (Section 471) and ordinary business expenses (Section 162) remains unchanged. The source of the confusion is that while expense treatment under Section 174 changed, the scope conditions of when expenses must be recorded under Section 174 did not.

Post-TCJA Considerations for Taxpayers

Until Congress addresses Section 174, taxpayers have three main options:

1) Accept the Original Stance

Taxpayers can accept the industry’s original stance that all expenses meeting the definition of research and experimentation must be recorded and amortized under Section 174. This is only feasible for companies with sufficient cash reserves, which may have been the case for some in 2022. However, many companies cannot pay the increased tax burden in 2023.

Note that this issue is insignificant for most companies doing R&D, as R&D typically represents a small percentage of the overall cost. Additionally, companies heavily engaged in R&D, such as start-ups, often have enough net operating losses to offset the amortization, preventing a tax liability. Accordingly, this law will not affect the overall economic viability of most companies. However, engineering-intensive companies, such as those operating on an engineer-to-order basis,  are acutely impacted and may be unable to take this option even if they wish to.

2) Minimize Classifying Expenses as R&D

Another approach is to minimize the expenses classified as R&D. This requires substantiating that the company’s activities do not meet the definition of research and experimentation. This is particularly necessary for taxpayers in industries with a history of claiming R&D tax credits. Additionally, taxpayers who previously claimed R&D tax credits can reasonably expect increased scrutiny.

Taxpayers may need to amend past returns to align with their new interpretation, paying the extra tax for those years. However, this approach may place companies at a long-term competitive disadvantage if the law is rewritten in a few years, as they would have fewer R&D tax credits than their rivals.

3) Read TCJA Sections 174 and 41 Together

The third approach is to read TCJA Sections 174 and 41 together, recognizing that the legislative text confirms Section 174 does not override other sections such as 471 (COGS) and 162 (ordinary and necessary expenses in the course of carrying on the business). This entails recording R&D under COGS or Section 162, thus maintaining consistency with historical filings. It avoids the middle-of-the-road position of claiming no R&D or fewer R&D expenses. It preserves the ability to maximize the R&D tax credit when the law changes, which could mean a more robust credit as there is considerable demand on Capitol Hill to make the U.S. R&D tax credit competitive with those in Europe and China.

Can Taxpayers Side-Step 174 Amortization?

No. Avoiding Section 174 amortization by not claiming Section 41 R&D tax credits is not viable. The application of Section 174 is independent of whether the taxpayer claims credits. Therefore, taxpayers must determine how Section 174 impacts their expenses meeting the R&E definition, regardless of whether they claim R&D tax credits.

Best Practice for Option Three

Taxpayers and CPAs who believe that the TCJA did not change the historical interplay of Section 174 with other code sections should continue to file their tax returns as they did before the TCJA. This means recording all project expenses as COGS and claiming eligible R&D tax credits. Including a disclosure statement can help protect against penalties if the IRS challenges this position.

Conclusion

Taxpayers and CPAs must decide now how to handle R&D expenses in light of the TCJA and the stalled legislative action. While awaiting potential changes in 2025 or 2026, businesses must strategically navigate the current tax landscape. This includes considering historical practices, the interplay of tax code sections, and different approaches' potential risks and benefits. The cavalry might not be coming soon, but informed decisions can mitigate the impact of these tax changes.

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.