The Congressional Debate Over Section 174 Changes

A change to Section 174 of the U.S. tax code, originating from the Tax Cuts and Jobs Act of 2017, became effective for tax years starting in 2022. This alteration dictates the tax treatment of research and experimental (R&E) expenditures and is a central issue in legislative debates. The new rule moved the tax treatment of these costs from an immediate deduction to a long-term amortization schedule.

The debate highlights the tension between generating federal revenue and fostering private-sector innovation. For businesses, the change directly impacts cash flow and financial modeling for research projects. Legislative efforts to reverse or delay this rule are being closely watched by companies that rely on research and development.

The Pre-2022 R&E Expensing Rule

For tax years beginning before January 1, 2022, Section 174 provided a favorable option for businesses. Companies could elect to deduct 100% of their qualified R&E costs in the same year those expenses were incurred. This immediate expensing directly reduced a company’s taxable income for the year, lowering its immediate tax liability and encouraging investment in innovation.

The primary advantage of this rule was its positive impact on a company’s cash flow. By deducting the full cost of research activities at once, businesses could retain more capital to reinvest into further development or expansion. For example, if a company spent $100,000 on qualifying research, it could reduce its taxable income by the full $100,000 in that same year.

This tax treatment lowered the after-tax cost of innovation and simplified tax preparation by eliminating the need for complex tracking of these expenses over many years.

The Shift to Mandatory Amortization

A change to Section 174, enacted as part of the Tax Cuts and Jobs Act of 2017, took effect for tax years starting after December 31, 2021. Under the new regulations, businesses are no longer permitted to immediately deduct their R&E expenditures. Instead, they must capitalize these costs and amortize them, spreading the deduction over a predetermined period. This change was a revenue-raising provision to help offset other tax cuts in the 2017 act.

The amortization period depends on where the research activities take place. For domestic R&E expenditures, the costs must be amortized over five years. For research conducted outside of the United States, a 15-year amortization period applies. The amortization must begin at the midpoint of the tax year when the expenses are incurred.

The new rule broadly defines R&E expenditures to include indirect expenses. All software development costs are now explicitly classified as R&E expenditures under Section 174, including the planning, design, coding, and testing phases.

This change means that instead of a full deduction in one year, a business recovers its investment over five or fifteen years. This results in higher taxable income in the short term, which can lead to a larger tax bill and reduced cash flow.

Congressional Efforts for a Legislative Fix

In response to the financial impact of mandatory amortization, there have been efforts in Congress to enact a legislative fix. The most prominent is the “Tax Relief for American Families and Workers Act of 2024.” This bill proposed to temporarily reverse the amortization requirement and restore the ability of businesses to immediately deduct their R&E expenses.

The bill’s proposal for Section 174 was to retroactively reinstate immediate expensing for domestic R&E costs for tax years 2022 through 2025. The proposed legislation did not, however, include a change to the 15-year amortization period for foreign R&E expenditures.

The bill passed the House of Representatives on January 31, 2024, with a bipartisan vote of 357 to 70.

Despite its success in the House, the bill’s progress was halted in the Senate. The legislation failed to secure the votes required to advance after some senators raised objections to other provisions, particularly those related to the expansion of the child tax credit.

This legislative deadlock leaves businesses to comply with the current amortization rules while hoping for a future legislative change.

Compliance with Current Section 174 Rules

Until Congress enacts a legislative change, businesses are required to comply with the mandatory amortization rules for R&E expenditures. This compliance process involves careful information gathering and specific procedural actions on the company’s tax return.

Information Gathering/Preparation

Businesses must establish a system to capture all costs associated with their research and experimental activities. This includes direct costs, indirect support costs, and other qualifying expenditures such as:

• Salaries and wages of researchers, engineers, and developers
• The cost of materials and supplies used in the R&E process
• Patent development costs, such as legal fees
• Fees paid to third-party contractors for development work

A component of this information-gathering process is the segregation of costs between domestic and foreign research activities. This is because the location of the research determines the amortization period. Accurate tracking and documentation are necessary to substantiate the allocation of these costs.

Procedural Action

Once all qualifying R&E expenditures have been identified and categorized, the total amount must be capitalized on the company’s books. This means the costs are treated as an asset rather than immediately expensed. The annual amortization deduction is then calculated based on the applicable five or fifteen-year period.

The annual amortization deduction is claimed on the company’s federal income tax return using Form 4562, Depreciation and Amortization, and reported in Part VI of the form.

For the first tax year a business is subject to these rules, it is considered a change in accounting method. The IRS has provided guidance that outlines the procedures for making this change, which may require filing Form 3115, Application for Change in Accounting Method, or attaching a statement to the tax return.