Can R&D Be Capitalized Under New Tax Rules?

Businesses invest resources to develop new products, improve existing processes, or create novel technologies. These investments often involve significant expenditures on research and development (R&D). For accounting purposes, these costs are generally treated as expenses incurred in the period they arise. However, the tax treatment of R&D expenditures can differ from their financial accounting treatment, leading to distinct implications for a company’s financial reporting and tax obligations. Understanding how these costs are handled for tax purposes is important for businesses to manage their financial position and ensure compliance with federal tax regulations.

Mandatory Capitalization of Research and Development Expenses

A significant change in tax law introduced by the Tax Cuts and Jobs Act (TCJA) of 2017 fundamentally altered how businesses treat research and development expenses for tax purposes. Prior to this legislation, Internal Revenue Code Section 174 allowed businesses the option to immediately deduct their R&D expenditures in the year they were incurred, offering an immediate reduction in taxable income. This approach incentivized innovation by lowering the immediate tax burden associated with research activities.

However, for tax years beginning after December 31, 2021, the TCJA mandated that R&D expenses can no longer be immediately expensed. Instead, these costs must be capitalized, meaning they are treated as an asset on a company’s balance sheet rather than a current deduction on its income statement. This shift requires businesses to recover the cost of their R&D investments over a period of years through amortization.

Companies that previously benefited from the immediate deduction now face an increase in their taxable income in the year the expenses are incurred. This can lead to higher tax liabilities, especially for businesses heavily engaged in R&D, such as those in manufacturing or software development. The inability to fully deduct these costs upfront can also impact a company’s cash flow, as more cash may be required for tax payments in the short term.

For example, a company with $1 million in domestic R&D expenses in a year would have previously deducted the full amount, reducing its taxable income by that much. Under the new rules, only a portion of that $1 million can be deducted in the first year, significantly increasing the company’s reported taxable income and, consequently, its tax obligations. This change applies to all R&D expenditures, regardless of whether a business claims the separate R&D tax credit under Internal Revenue Code Section 41. Compliance with the capitalization requirement is mandatory.

Defining Qualified Research Expenses

Understanding which expenditures fall under the mandatory capitalization rule requires a clear definition of “qualified research expenses” (QREs). For tax purposes, QREs are specific costs incurred during the development or improvement of products, processes, techniques, formulas, inventions, or software that meet specific IRS requirements. These expenses are associated with research and experimentation in an experimental or laboratory sense.

To be considered qualified research, an activity must satisfy a four-part test:
The research must be intended to develop a new or improved function, performance, reliability, or quality for a business component.
There must be an elimination of uncertainty regarding the appropriate design, capability, or method of development for the business component.
The activity must involve a process of experimentation, evaluating alternatives to achieve a desired result.
The research must be technological in nature, relying on principles of physical or biological sciences, engineering, or computer science.

Examples of costs that qualify as QREs include wages paid to employees for performing qualified research services, the cost of supplies used in the conduct of qualified research, and amounts paid to contractors for performing qualified research activities on behalf of the taxpayer. Salaries for engineers designing a new product or the cost of raw materials used in prototyping would qualify. Only a percentage of contract research expenses (65%) can be considered QREs.

Conversely, certain types of activities and associated costs do not qualify. These include research conducted outside the United States, costs for ordinary testing or quality control, market research, management studies, or research related to style, taste, or cosmetic design factors. General administrative or managerial duties, even if performed within a research department, are excluded. Costs for land, land improvements, or depreciable property like research facilities or equipment are also not considered QREs.

Amortization Rules for Capitalized Research and Development

Once R&D expenses are capitalized, businesses must amortize these costs over a specified period, deducting a portion of the expense each year for tax purposes. The specific amortization period depends on where the research activities are conducted.

For domestic R&D expenses, the capitalized costs must be amortized over a five-year period. If the R&D is performed in a foreign jurisdiction, the amortization period extends to 15 years. The amortization period begins at the midpoint of the taxable year in which the expenses are paid or incurred. This “half-year convention” means that in the first year, only half of the annual amortized amount is deductible, regardless of when the expense was incurred during that year.

For example, if a company incurs $100,000 in domestic R&D expenses in a given year, under the five-year amortization rule, it would deduct $20,000 (1/5th) each year. However, due to the half-year convention, in the first year, the deduction would be $10,000 (half of $20,000). The remaining $90,000 would then be spread over the subsequent four and a half years. The full deduction for a single year’s R&D expenses is ultimately spread across six tax years.

Compared to immediate expensing, the deferral of deductions increases a company’s taxable income in the earlier years, leading to higher tax payments. This can be particularly challenging for companies with significant R&D investments or those that are newly profitable. The longer amortization period for foreign R&D also adds a financial disincentive for conducting research outside the United States.

Even if property related to capitalized R&D expenses is disposed of, retired, or abandoned during its amortization period, the unamortized portion of the R&D expenses cannot be immediately recovered. Instead, businesses must continue to amortize those costs over the original five or 15-year period. While legislative efforts have been made to restore immediate expensing, the current requirement to capitalize and amortize R&D expenses remains the law.