Frost Law
For decades, the I.R.C. Section 41 credit for increasing research activities (“R&D tax credit”) has offered substantial annual tax savings to businesses that develop or improve products and technical processes within the United States. The credit is a leading program within the U.S. federal government to subsidize research activity and is a significant annual tax expenditure, but also has historically been underutilized for a variety of reasons.
In recent years, the usage of the credit has declined as an indirect result of a change in tax accounting built into the Tax Cuts and Jobs Act (“TCJA”)(2017). Beginning in 2022, taxpayers had to capitalize research costs under I.R.C. Section 174, which had the effect of temporarily increasing the tax burden on companies engaged in research activities, contrary to decades of government policy. The R&D tax credit has remained a valuable permanent savings opportunity, but the new, unfavorable accounting treatment disincentivized research and led many taxpayers to define their research as narrowly as the law permitted.
This article addresses the background and prospects for both R&D tax credits and I.R.C. Section 174 capitalization in light of expected federal tax legislation in 2025.
I.R.C. Section 174 addresses tax accounting for research in general and forms the basis for R&D tax credit eligibility under Section 41. The regulations to Section 174 provides the definition of “research or experimental expenditures” (“SREs”) in Treas. Reg. Section 1.174-2(a)(1) –
. . . Expenditures represent research and development costs . . . if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. Whether expenditures qualify as research or experimental expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement [it] represents. The ultimate success, failure, sale, or use of the product is not relevant to a determination of eligibility . . . Costs may be eligible under section 174 . . . after production begins but before uncertainty concerning the development or improvement of the product is eliminated.
The I.R.C. Section 174 and 41 statutes and regulations provide additional criteria, exclusions, and examples, but the Treas. Reg. Section 1.174-2(a)(1) definition above effectively defines “research” for federal tax purposes. The additional criteria under Section 41 largely restate and clarify the same concepts, which are addressed in more detail below. Sections 174 and 41 differ primarily with respect to which costs are included. Section 174 covers all research expenditures, whereas the Section 41 R&D tax credit is only available for U.S.-based labor, applies a 35% reduction to contract labor costs, and excludes overhead expenses, along with several other differences.
Until the I.R.C. Section 174 capitalization rule took effect in 2022, taxpayers typically had little reason to determine their specific amount of SREs, since research costs were currently deductible (with a capitalization election). The onset of the capitalization rule had a substantial impact on how taxpayers approached their research costs. While the R&D tax credit had always been optional, legally Section 174 required a determination of the appropriate amount of SREs. Tax preparers faced this new requirement with limited guidance from the I.R.S., resulting in significant challenges and uncertainty for taxpayers. By the beginning of 2025, the I.R.S. had published additional guidance, and tax practitioners were better positioned to comply with the rules.
For taxpayers, however, the situation has remained difficult. The capitalization rule onset created a temporary timing difference because there were no existing expenditures on the books. Compared to the previous rule, many taxpayers have faced large increases in taxable income without any change in business profitability. The ambiguous classification of some activities from a research perspective led many taxpayers to identify research activities to the most limited possible extent consistent with the applicable sources of authority. Since I.R.C. Section 41 credits must meet the criteria of Section 174 as well, the result for those taxpayers has often included a greatly reduced or zero R&D tax credit amount.
Disincentives to research are contrary to Congress’s long-term priority of promoting research activities, but attempted legislative fixes have not yet been successful. Congress is widely expected to pass tax legislation in 2025, owing to the expiration of increasingly significant portions of the TCJA. As part of that legislation, many taxpayers and advocacy organizations will urge lawmakers to restore the current deductibility of research costs, removing the negative effects of capitalization. Though research incentives often have bipartisan support and are likely to be addressed by the legislation, the U.S. budget deficit and competing tax priorities could force Congress to prioritize some benefits over others.
In the event that legislation restores research expensing, Congress will also have to consider whether the change should be retroactive and how remaining capitalized research costs should be treated. In legislation that passed the House of Representatives in January 2024, the restored expensing was made retroactive and remaining capitalized research costs became currently deductible. The treatment of those items in the upcoming legislation would have a significant impact for many taxpayers. For instance, taxpayers with large amounts of capitalized research could generate large additional deductions compared to continued amortization.
Research expensing would also restore the tax incentive structure to support research activities. Though the R&D tax credit has remained available as before, the capitalization rules discouraged taxpayers from fully utilizing the program. Under expensing, the compliance challenges of capitalization are removed, and taxpayers have the choice of whether to pursue R&D tax credits.
Eligibility for the R&D tax credit closely follows the general definition of “research” quoted above, but the rules provide for a “four-part test,” which the regulations address in Treas. Reg. Section 1.41-4(a).
Treas. Reg. Section 1.41-4(a)(2)(i) provides the first part of the test, which is that the activities must meet the definition of research under I.R.C. Section 174, specifically the requirement for uncertainty, which “exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product” (Treas. Reg. Section 1.174-2(a)(1)). Uncertainty exists when a taxpayer has multiple alternatives and has to go through iterations to determine what the final design or process will be.
Treas. Reg. Section 1.41-4(a)(2)(ii) provides the second part of the test, which is that the information being discovered must be “technological in nature.”
Information is technological in nature if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. A taxpayer may employ existing technologies and may rely on existing principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement. (Treas. Reg. Section 1.41-4(a)(4)).
Taxpayers should note the emphasis on “existing” technologies and principles – the credit is incentivizing the process of development and improvement, rather than the level of innovation or ultimate results. Research and development by its nature is an incremental process, building on what has been established before. The most important effect of this part of the test is to exclude activities that are based on social sciences, such as marketing, accounting, management or personnel strategy, and other such functions. Purely aesthetic considerations are likewise not technological in nature.
Treas. Reg. Section 1.41-4(a)(2)(ii) also provides the third part of the test, that the taxpayer’s activities must be intended to develop a new or improved business component. The I.R.C. Section 41(d)(2)(B) statute provides that a business component is “any product, process, computer software, technique, formula, or invention which is to be – (i) held for sale, lease, or license, or (ii) used by the taxpayer in a trade or business of the taxpayer.” The determination of business components is particular to each company and in practice covers the vast majority of potential activities, making this part of the test more of an administrative task than a research criteria.
Treas. Reg. Section 1.41-4(a)(2)(iii) provides the fourth and final part of the test, which is that “[s]ubstantially all of the activities [to develop a new or improved business component] constitute elements of a process of experimentation that relates to a qualified purpose.” This requirement follows from the “uncertainty” part of the test – since there is uncertainty, the taxpayer’s “research” is the effort made to resolve the uncertainty. Treas. Reg. Section 1.41-4(a)(5) provides a lengthy description of the “process of experimentation,” which focuses on the consideration of alternatives and use of iterations. Those characteristics are relied on to separate eligible research from other, non-qualifying activities.
To summarize, the R&D tax credit’s four-part test requires – (i) uncertainty over design or process, (ii) that the activities are technological in nature and (iii) intended to develop a new or improved business component, and that (iv) the qualified activities should constitute a process of experimentation to resolve the uncertainty. Additionally, labor must be performed within the U.S. to be eligible.
I.R.C. Section 41 provides for two methods of calculating R&D tax credits, the “regular” method and the “Alternative Simplified Credit.” The mechanics of the calculations are beyond the scope of this article and can be technically complex. Both calculation methods are structured to incentivize increasing research compared to a base amount of research activity in prior tax years. Assuming a return to research expensing, a typical taxpayer can expect a yield of around 7.5% in credits based on eligible research costs.
The eligible costs include the wages, contract research (at 65%), supplies (materials), and cloud computing resources associated with qualifying research activities under the four-part test described above. Once those amounts are identified and grouped into business components, the taxpayer is able to compute the credit amount. Due to the potential complexity of the calculations, taxpayers should generally seek expert assistance with the process of determining eligible activities and costs and calculating the resulting credit.
Given the upcoming tax legislation and potential value of R&D tax credits to many businesses, taxpayers should consider how the potential rules change may impact existing and future tax planning. Please reach out to us for a complimentary assessment in order to determine the benefits available to you. If an opportunity is identified, we will work with your team or outside tax preparers to consider how the R&D tax credit fits in with your overall tax strategy. Talk to our team today at (410) 497-5947 or schedule a confidential consultation.
For decades, the I.R.C. Section 41 credit for increasing research activities (“R&D tax credit”) has offered substantial annual tax savings to businesses that develop or improve products and technical processes within the United States. The credit is a leading program within the U.S. federal government to subsidize research activity and is a significant annual tax expenditure, but also has historically been underutilized for a variety of reasons.
In recent years, the usage of the credit has declined as an indirect result of a change in tax accounting built into the Tax Cuts and Jobs Act (“TCJA”)(2017). Beginning in 2022, taxpayers had to capitalize research costs under I.R.C. Section 174, which had the effect of temporarily increasing the tax burden on companies engaged in research activities, contrary to decades of government policy. The R&D tax credit has remained a valuable permanent savings opportunity, but the new, unfavorable accounting treatment disincentivized research and led many taxpayers to define their research as narrowly as the law permitted.
This article addresses the background and prospects for both R&D tax credits and I.R.C. Section 174 capitalization in light of expected federal tax legislation in 2025.
I.R.C. Section 174 addresses tax accounting for research in general and forms the basis for R&D tax credit eligibility under Section 41. The regulations to Section 174 provides the definition of “research or experimental expenditures” (“SREs”) in Treas. Reg. Section 1.174-2(a)(1) –
. . . Expenditures represent research and development costs . . . if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. Whether expenditures qualify as research or experimental expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement [it] represents. The ultimate success, failure, sale, or use of the product is not relevant to a determination of eligibility . . . Costs may be eligible under section 174 . . . after production begins but before uncertainty concerning the development or improvement of the product is eliminated.
The I.R.C. Section 174 and 41 statutes and regulations provide additional criteria, exclusions, and examples, but the Treas. Reg. Section 1.174-2(a)(1) definition above effectively defines “research” for federal tax purposes. The additional criteria under Section 41 largely restate and clarify the same concepts, which are addressed in more detail below. Sections 174 and 41 differ primarily with respect to which costs are included. Section 174 covers all research expenditures, whereas the Section 41 R&D tax credit is only available for U.S.-based labor, applies a 35% reduction to contract labor costs, and excludes overhead expenses, along with several other differences.
Until the I.R.C. Section 174 capitalization rule took effect in 2022, taxpayers typically had little reason to determine their specific amount of SREs, since research costs were currently deductible (with a capitalization election). The onset of the capitalization rule had a substantial impact on how taxpayers approached their research costs. While the R&D tax credit had always been optional, legally Section 174 required a determination of the appropriate amount of SREs. Tax preparers faced this new requirement with limited guidance from the I.R.S., resulting in significant challenges and uncertainty for taxpayers. By the beginning of 2025, the I.R.S. had published additional guidance, and tax practitioners were better positioned to comply with the rules.
For taxpayers, however, the situation has remained difficult. The capitalization rule onset created a temporary timing difference because there were no existing expenditures on the books. Compared to the previous rule, many taxpayers have faced large increases in taxable income without any change in business profitability. The ambiguous classification of some activities from a research perspective led many taxpayers to identify research activities to the most limited possible extent consistent with the applicable sources of authority. Since I.R.C. Section 41 credits must meet the criteria of Section 174 as well, the result for those taxpayers has often included a greatly reduced or zero R&D tax credit amount.
Disincentives to research are contrary to Congress’s long-term priority of promoting research activities, but attempted legislative fixes have not yet been successful. Congress is widely expected to pass tax legislation in 2025, owing to the expiration of increasingly significant portions of the TCJA. As part of that legislation, many taxpayers and advocacy organizations will urge lawmakers to restore the current deductibility of research costs, removing the negative effects of capitalization. Though research incentives often have bipartisan support and are likely to be addressed by the legislation, the U.S. budget deficit and competing tax priorities could force Congress to prioritize some benefits over others.
In the event that legislation restores research expensing, Congress will also have to consider whether the change should be retroactive and how remaining capitalized research costs should be treated. In legislation that passed the House of Representatives in January 2024, the restored expensing was made retroactive and remaining capitalized research costs became currently deductible. The treatment of those items in the upcoming legislation would have a significant impact for many taxpayers. For instance, taxpayers with large amounts of capitalized research could generate large additional deductions compared to continued amortization.
Research expensing would also restore the tax incentive structure to support research activities. Though the R&D tax credit has remained available as before, the capitalization rules discouraged taxpayers from fully utilizing the program. Under expensing, the compliance challenges of capitalization are removed, and taxpayers have the choice of whether to pursue R&D tax credits.
Eligibility for the R&D tax credit closely follows the general definition of “research” quoted above, but the rules provide for a “four-part test,” which the regulations address in Treas. Reg. Section 1.41-4(a).
Treas. Reg. Section 1.41-4(a)(2)(i) provides the first part of the test, which is that the activities must meet the definition of research under I.R.C. Section 174, specifically the requirement for uncertainty, which “exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product” (Treas. Reg. Section 1.174-2(a)(1)). Uncertainty exists when a taxpayer has multiple alternatives and has to go through iterations to determine what the final design or process will be.
Treas. Reg. Section 1.41-4(a)(2)(ii) provides the second part of the test, which is that the information being discovered must be “technological in nature.”
Information is technological in nature if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. A taxpayer may employ existing technologies and may rely on existing principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement. (Treas. Reg. Section 1.41-4(a)(4)).
Taxpayers should note the emphasis on “existing” technologies and principles – the credit is incentivizing the process of development and improvement, rather than the level of innovation or ultimate results. Research and development by its nature is an incremental process, building on what has been established before. The most important effect of this part of the test is to exclude activities that are based on social sciences, such as marketing, accounting, management or personnel strategy, and other such functions. Purely aesthetic considerations are likewise not technological in nature.
Treas. Reg. Section 1.41-4(a)(2)(ii) also provides the third part of the test, that the taxpayer’s activities must be intended to develop a new or improved business component. The I.R.C. Section 41(d)(2)(B) statute provides that a business component is “any product, process, computer software, technique, formula, or invention which is to be – (i) held for sale, lease, or license, or (ii) used by the taxpayer in a trade or business of the taxpayer.” The determination of business components is particular to each company and in practice covers the vast majority of potential activities, making this part of the test more of an administrative task than a research criteria.
Treas. Reg. Section 1.41-4(a)(2)(iii) provides the fourth and final part of the test, which is that “[s]ubstantially all of the activities [to develop a new or improved business component] constitute elements of a process of experimentation that relates to a qualified purpose.” This requirement follows from the “uncertainty” part of the test – since there is uncertainty, the taxpayer’s “research” is the effort made to resolve the uncertainty. Treas. Reg. Section 1.41-4(a)(5) provides a lengthy description of the “process of experimentation,” which focuses on the consideration of alternatives and use of iterations. Those characteristics are relied on to separate eligible research from other, non-qualifying activities.
To summarize, the R&D tax credit’s four-part test requires – (i) uncertainty over design or process, (ii) that the activities are technological in nature and (iii) intended to develop a new or improved business component, and that (iv) the qualified activities should constitute a process of experimentation to resolve the uncertainty. Additionally, labor must be performed within the U.S. to be eligible.
I.R.C. Section 41 provides for two methods of calculating R&D tax credits, the “regular” method and the “Alternative Simplified Credit.” The mechanics of the calculations are beyond the scope of this article and can be technically complex. Both calculation methods are structured to incentivize increasing research compared to a base amount of research activity in prior tax years. Assuming a return to research expensing, a typical taxpayer can expect a yield of around 7.5% in credits based on eligible research costs.
The eligible costs include the wages, contract research (at 65%), supplies (materials), and cloud computing resources associated with qualifying research activities under the four-part test described above. Once those amounts are identified and grouped into business components, the taxpayer is able to compute the credit amount. Due to the potential complexity of the calculations, taxpayers should generally seek expert assistance with the process of determining eligible activities and costs and calculating the resulting credit.
Given the upcoming tax legislation and potential value of R&D tax credits to many businesses, taxpayers should consider how the potential rules change may impact existing and future tax planning. Please reach out to us for a complimentary assessment in order to determine the benefits available to you. If an opportunity is identified, we will work with your team or outside tax preparers to consider how the R&D tax credit fits in with your overall tax strategy. Talk to our team today at (410) 497-5947 or schedule a confidential consultation.
