State Conformity to Section 174 R&E Amortization

A 2017 federal tax law change regarding the treatment of research and experimentation (R&E) expenditures became effective in 2022. This modification has created a varied landscape for state-level taxation, as states have taken different approaches to adopting this federal rule. This divergence in policy means that the tax treatment of identical R&E costs can vary substantially from one state to another, creating a complicated compliance environment for businesses.

The Federal Mandate for R&E Amortization

Prior to the changes enacted by the Tax Cuts and Jobs Act (TCJA) of 2017, businesses could immediately deduct their R&E costs in the year they were incurred. This long-standing policy allowed for a 100% upfront deduction, which encouraged investment in innovation by providing an immediate tax benefit. This practice was straightforward, aligning the tax deduction with the cash outlay for the research.

For tax years beginning after December 31, 2021, Internal Revenue Code (IRC) Section 174 mandates a different approach. The law now requires businesses to capitalize all specified R&E expenditures and amortize them over a predetermined period. The shift from immediate deduction to amortization means the tax benefit is spread out over several years, which can lead to a higher tax liability in the year the expenses are paid.

The definition of “specified research or experimental expenditures” is broad and encompasses a wide range of activities. It includes costs incident to the development or improvement of a product, a component of a product, or a pilot model. A component of these specified expenditures is the inclusion of software development costs, which were often previously expensed immediately.

The law establishes two distinct amortization schedules based on where the research activities are conducted. For R&E expenditures attributable to research performed within the United States, the costs must be amortized over a five-year period. In contrast, costs for research conducted outside of the United States are subject to a much longer fifteen-year amortization period. This policy was designed to incentivize domestic research and development. The amortization begins at the midpoint of the taxable year in which the expenditure is paid or incurred, a detail known as the mid-year convention.

However, this federal mandate may be changing. In May 2025, the U.S. House of Representatives passed legislation that, if enacted, would suspend the requirement to amortize domestic R&E expenditures for tax years beginning after December 31, 2024. Under the proposed bill, businesses would have the option to deduct domestic R&E costs in the year they are incurred. The law requiring a 15-year amortization period for foreign research would remain in effect.

Mechanisms of State Tax Conformity

States generally base their income tax systems on the federal tax code, but the method and timing of this adoption create differences in how federal changes are handled. The primary mechanism for this is known as conformity. Understanding how a state conforms to the Internal Revenue Code is fundamental to determining its treatment of the Section 174 amortization mandate.

One common approach is “rolling conformity,” where a state’s tax code automatically incorporates federal changes as they are enacted by Congress. In these states, the state’s definition of taxable income is continuously updated to match the current federal definition. For a change like the Section 174 mandate, a rolling conformity state would automatically adopt the amortization requirement.

Another method is “static” or “fixed-date” conformity. States using this approach tie their tax laws to the Internal Revenue Code as it existed on a specific date. Any federal tax law changes enacted after this fixed date are not automatically adopted. For these states to incorporate a new federal provision, their state legislature must pass a law to update the conformity date.

A third approach is “selective conformity,” which is a hybrid model. States with selective conformity may adopt large portions of the IRC but explicitly “decouple” from or reject specific provisions. This allows a state to pick and choose which federal tax rules it will follow. A state might, for example, pass a specific law to decouple from the Section 174 amortization requirement, allowing businesses to continue expensing R&E costs.

State Positions on R&E Deductions

The federal mandate requiring the amortization of R&E expenditures has led to a divided response among the states. States’ positions are primarily dictated by their method of conformity to the Internal Revenue Code. This has resulted in states that conform to the new federal rule and states that have decoupled and allow immediate expensing.

A significant number of states conform to the IRC Section 174 amortization requirement. This group includes states with rolling conformity, as they automatically adopt federal tax law changes. It also includes static conformity states that have proactively updated their conformity dates. For businesses in these conforming states, the state tax treatment of R&E costs mirrors the federal rule.

Conversely, a number of states have decoupled from the federal changes and continue to allow for the immediate deduction of R&E expenditures. These are typically static conformity states whose fixed conformity date precedes the TCJA’s effective date for the Section 174 change. Some states have also passed specific legislation to decouple from this provision, choosing to maintain the immediate deduction.

Calculating State Taxable Income Adjustments

For businesses operating in states that have decoupled from the federal Section 174 amortization mandate, calculating state taxable income requires specific adjustments. The process begins with the federal taxable income figure, which serves as the starting point for most state corporate income tax returns. This federal number has already been reduced by the allowable federal R&E amortization deduction for the year.

The first step in the state-level calculation is an addition modification. The taxpayer must add back the amount of the R&E amortization that was deducted on the federal return. This adjustment effectively cancels out the federal treatment of the R&E costs, increasing the state’s preliminary taxable income.

Following the addition, the business makes a subtraction modification. The taxpayer is permitted to subtract the entire amount of the R&E expenditures paid or incurred during that specific tax year. This is because the decoupling state continues to follow the pre-TCJA rule allowing for immediate, 100% expensing of these costs.

Consider a simplified example: a business incurs $100,000 in domestic R&E costs in a given year. For federal purposes, it must amortize this over five years, resulting in a first-year deduction of $10,000 (using the mid-year convention). On its state return in a decoupled state, the business would first add back the $10,000 federal amortization deduction. Then, it would make a subtraction modification for the full $100,000 of R&E costs, resulting in a net state deduction that is $90,000 larger than the federal deduction for that year.

This process creates a book-tax difference between the federal and state basis of the capitalized R&E assets. The federal basis will be reduced slowly over the five or fifteen-year amortization period, while the state basis is reduced to zero in the first year. This requires careful tracking of these differing basis amounts over the entire federal amortization period to ensure that state taxable income is calculated correctly in future years, as no further state deductions for these specific costs will be allowed.