In the wake of industry-wide complacency, a critical part of the 2017 Tax Cuts and Jobs Act took effect at the start of 2022. The changes to the Internal Revenue Code Section 174—eliminating the ability for taxpayers to deduct research and experimentation expenses—have raised concerns. A significant piece of the original intent, which was to give startups access to the same deductions as established businesses, was negated. Instead of Section 174 allowing taxpayers to deduct or amortize expenses, the Tax Cuts and Jobs Act now only mandates amortization.
While it’s understandable that some want to sound the alarm on these potential threats to innovation within the US manufacturing sector, most companies should not experience a major upheaval to their tax picture.
If the rule changes were to govern the R&E expenses of all foreign or domestic businesses with significant R&E expenses, those businesses likely would experience a noticeable tax increase. The effect would be painful, with a five-year amortization for domestic R&E and 15 years for foreign R&E. It likely would force companies to choose between cash flow, borrowing, or even reducing R&E activities.
But the rule change does not govern all businesses; it only affects startups.
The domestic consequence for those who misinterpret how Section 174 operates would be catastrophic for companies whose trade or business involves engineering; custom designs; or custom products, equipment, and systems. Consider the fate of an engineering business whose activities are almost exclusively R&E expenses as defined in Section 174. If this company had $10 million in project expenses and $2 million in taxable income, the company would assume it is required to restate its taxable income to $11.5 million from $2 million, forcing it to make unattractive budgetary and cash-flow decisions.
In reality, there is no change to how these expenses are treated for businesses beyond the startup phase. It’s common to conflate the Section 174 treatment with the Section 174 definition of R&E expenses. To understand why this distinction exists, we have to understand our legislative and judicial history regarding the birth of Section 174 as well as its current application.
Why Conclude Section 174 Applies to All Taxpayers?
The accounting industry declared—virtually in one voice—that in the wake of Section 174 Tax Cuts and Jobs Act amendments, all R&E expenses fall under the purview of Section 174. The industry asserts that prior to the changes, there was no reason to differentiate between Section 174 and Section 162 expenses. Each allows the taxpayer to deduct or amortize their R&E expenses. Until recently, there was scant industry discussion of this issue. Privately, however, practitioners admit they expect the changes to be revoked and have not given them serious consideration.
One source of confusion is the general misunderstanding of Section 174 and why it was enacted. Section 174 was born in 1954, shortly after President Dwight D. Eisenhower addressed Congress with the concern that adverse tax rules allowed established companies to deduct their R&E expenditures, but those same activities conducted by start-up businesses could not be deducted. In Section 174, Congress mirrored Section 162’s language that “there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business,” with the sole change of the qualifier “carrying on” to “in connection with.”
Twenty years later, the Warren Burger-led Supreme Court ruled that the purview of Section 174 was as Congress intended: to eliminate the inequity between start-up businesses that were not yet carrying on their trade or business and existing companies that could do so with respect to R&E expenses under Section 162. This Supreme Court ruling is reflected in cases as recent as the summer of 2022.
Another source of confusion is that Section 41 references the definition of R&E expenses found in Section 174. The industry’s simplification posits that because Section 41 expenses invoke Section 174, those expenses must receive Section 174 treatment. However, Section 41 does not require Section 174 treatment. Instead, it stipulates that if the expenses qualify under the definition of R&E expenses found in Section 174, the taxpayer is allowed to utilize Section 41 for R&D tax credit calculations. The treatment of expenses is undisturbed by Section 41.
Is Section 174 Needed to Deduct R&E Expenses?
In a word, no. During the Supreme Court oral arguments regarding Section 174, the IRS commissioner said that any ongoing business with a history of R&E expenditures could use Section 162, regardless of whether the new activities were in the same trade or business. Only new entities were denied Section 162 treatment because they have not yet reached the stage of holding themselves out as providing the goods or services for which they were organized—the judicial standard for meeting the “carrying on a trade or business” distinction. In other words, existing businesses do not require Section 174 to deduct R&E expenses because they have access to Section 162.
What Qualifies as a Start-Up for Section 174?
In 2003, the IRS chief of counsel issued a memorandum stating that a company must be entering a new trade or business to fall under the purview of startup provisions. This addressed Section 195, which also intended to eliminate the inequity between start-ups and existing businesses. Most businesses are in the “carrying on” stage; only new enterprises that don’t meet the carrying-on standard are governed by Section 174 with respect to the tax treatment of R&E expenses.
Where Does This Leave Us?
Congress could revoke the Section 174 rule change, but it would still need to reach an agreement on another revenue-raising provision to make up the expected shortfall from such a revocation. Congress could rewrite the rules requiring amortization of all R&E expenses for both start-ups and existing businesses, although it is unclear how they could do so without a major rewriting of multiple sections of the IRC. Both tasks would test legislators’ stamina and resolve.
In the meantime, the Section 174 amendment should not cause established taxpayers to adjust their accounting methods when applying Section 162. Existing taxpayers incurring R&E costs as part of their ordinary and necessary expenses while carrying on a trade or business can continue to make deductions with confidence that legislative and judicial history support that practice.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Rick Kleban is founder and president of Sycamore Growth Group, a Dublin, Ohio-based firm that specializes in helping small- and medium-sized businesses, primarily manufacturing companies, attain and substantiate R&D tax credits. He assists companies in identifying eligible R&D expenses and oversees a team of professionals who substantiate how each underlying project and associated expenses meet the requirements of Section 41.
Daniel Reinier is senior tax credit manager at Sycamore Growth Group. He directs the firm’s efforts regarding the collection and interpretation of client data, as well as the calculation of the credits.
James Bean is senior analyst at Sycamore Growth Group. He specializes in investigating tax issues that affect Sycamore’s diverse clientele.
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