What Are the New R&D Capitalization Rules?

A change from the Tax Cuts and Jobs Act of 2017 (TCJA) has altered how businesses treat their research and development costs. For tax years beginning after December 31, 2021, companies are no longer permitted to deduct these expenses in the year they are incurred. Instead, the law mandates that businesses must capitalize these costs and amortize them over several years.

This requirement has been controversial. In early 2024, the U.S. House of Representatives passed the Tax Relief for American Families and Workers Act, which included a provision to temporarily restore immediate deductions for domestic R&D expenses. While that bill has not passed the Senate, strong bipartisan support means the rule’s future is uncertain.

For now, the capitalization rule is mandatory and has broad implications for any company engaged in R&D.

The Core Change to R&D Expense Treatment

The historical treatment of research and development expenses under Internal Revenue Code (IRC) Section 174 provided businesses with flexibility. For decades, a company could treat its R&D expenditures as current expenses and deduct them fully in the tax year they were incurred. This approach, a feature of the tax code since 1954, accelerated tax deductions and improved cash flow. The TCJA reversed this long-standing provision, mandating capitalization and amortization. This means businesses must now treat R&D costs as a capital asset, with the cost deducted gradually over a multi-year period.

This change from immediate deduction to a delayed recovery of costs is a significant shift in tax policy. The requirement is mandatory for all businesses that incur these types of expenses, regardless of their size or industry. The impact is a deferral of tax deductions, which can lead to higher taxable income and increased tax payments in the short term.

Identifying Specified Research or Experimental Expenditures

To comply with the new rules, a business must first identify all costs that fall under the definition of “specified research or experimental” (SRE) expenditures. The scope of these costs is broad and encompasses more than just the salaries of scientists in a lab. The definition includes all costs incidental to the development or improvement of a product, which can be a process, formula, invention, or similar property.

Direct costs include the wages and salaries of employees directly engaged in R&D activities or those who directly supervise these activities. The cost of materials and supplies consumed during the research process also falls into this category. For example, the cost of raw materials used to create a prototype are considered direct SRE expenditures.

The rules also require the capitalization of many indirect costs that support the R&D function. This includes overhead expenses that are properly allocable to research departments or projects. Examples of such costs are rent for the portion of a facility used for R&D, utilities servicing that space, and depreciation on equipment used in research activities.

Software Development

A specific area within SREs is software development. The guidance includes all costs associated with the development of computer software, whether for internal use or for sale or license to others. This means that the salaries of programmers, testers, and project managers working on a new software application must be capitalized. The rule applies regardless of whether the development is performed by employees or by third-party contractors.

Amortization and Disposition of R&E Costs

Once a company has identified its total SRE expenditures for the year, it must amortize these costs over a predetermined period. The length of this period depends entirely on where the research activities took place. For SREs attributable to research conducted within the United States, the capitalized costs must be amortized over a five-year period. If the research is conducted in a foreign country, a much longer 15-year amortization period applies.

A specific accounting rule, the mid-year convention, applies to the amortization of these costs. This convention dictates that amortization begins from the midpoint of the tax year in which the expenses are incurred, regardless of when the costs arose. This means that for the first year, the business can only deduct half of a full year’s amortization.

To illustrate, consider a company that incurs $500,000 in domestic R&E costs during a tax year. The annual amortization amount over five years would be $100,000 ($500,000 / 5). However, due to the mid-year convention, the deduction in Year 1 is only $50,000. For Years 2 through 5, the company would deduct the full $100,000 each year, with the final $50,000 deducted in the first half of Year 6.

The rules also address what happens if the property or project associated with the R&E costs is disposed of, retired, or abandoned before the end of the amortization period. In such an event, the business cannot immediately write off the remaining unamortized balance. Instead, the company must continue to amortize the remaining capitalized costs over the rest of the original five-year or 15-year period. This prevents an accelerated deduction even if the underlying research project is a complete failure.

Required Change in Accounting Method

The transition from immediately deducting R&D expenses to capitalizing and amortizing them is considered a change in accounting method. While taxpayers are normally required to receive permission from the IRS to change an accounting method, the IRS has provided simplified procedures for this specific change. Businesses must formalize this change by filing a specific form with their federal income tax return for the first tax year the new rules apply.

The required document is IRS Form 3115, Application for Change in Accounting Method. For this particular change, the IRS has issued revenue procedures that allow taxpayers to file for an automatic change, which does not require advance consent from the IRS. This simplifies the compliance process considerably.

Filing Form 3115 is a mandatory step for compliance. The change is made on a “cut-off” basis, meaning the new method of capitalization only applies to R&E costs paid or incurred in tax years beginning after December 31, 2021. Any costs from prior years are not affected and continue to be treated under the old rules.