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These new rules create a welcome opportunity for companies conducting research domestically to improve cash flow, while also providing much-needed flexibility. Here are several key things companies should know and need to consider:
These new rules apply to many activities!
The first step is for organizations to accurately gauge what percent of their workers’ time and salaries are devoted to R&D, and verify that this work meets the qualifications of what is considered R&D based on a four-part test: permitted purpose; process of experimentation; elimination of uncertainty; and technological in nature.
Even with these stipulations, that’s a lot of work that’s covered; it’s not just people in lab coats anymore. Businesses in many different industries may qualify for full domestic R&D expensing and other domestic R&D-related tax credits. Any organization that’s developing a new product, procedure, technique or invention using scientific principles may qualify.
Immediate expensing or capitalization and amortization?
Under the new rules, companies have the option of immediately deducting their full domestic R&D expenditures for a given tax year, or capitalizing and amortizing these expenditures over a five-year period (for foreign R&D, the rules remain the same — capitalization and amortization over 15 years).
Taking an immediate deduction will be the default option for most U.S. businesses, given the promise of freeing up cash flow. However, there are times when organizations should consider sticking with five-year capitalization and amortization, such as when they hold a lot of high-interest debt. The OBBBA restored the “D” and the “A” (depreciation and amortization) in EBITDA, allowing these amounts to be added back to adjusted taxable income (ATI) and therefore increasing the business interest expense limitation. This essentially makes the business interest expense limitation and full R&D expenditures competing interests, and businesses will need to conduct careful modeling to determine what approach is more advantageous to their tax posture. Companies that are pass-through entities should also carefully consider any potential impact on their Section 199A deduction as the retroactive change in taxable income may impact their deduction.
Alignment with R&D tax credit
While both are related to research expenses, the R&D tax credit and the previous R&D expensing rules (which required capitalization and amortization) traditionally operated independently. This often created misalignment because a company’s taxable income could increase significantly even as it qualified for a tax credit. With the OBBBA, a company can still get the benefits of full domestic R&D expensing while simply electing the reduced credit under IRC 280C.
The first path is often chosen by companies with significant tax liability, while the second is often preferred by startups and early-stage companies that may not have enough income tax liability to use the credit immediately.
Qualified small businesses with less than $5 million in gross receipts also have the option of applying the tax credit to their payroll taxes. Companies must have less than five years of total revenue to qualify to utilize the credit against payroll taxes. With numerous options available to coordinate new R&D capitalization rules with credits, modeling is once again the key to determining which approach is most advantageous.
Accelerated deductions and retroactive options
The OBBBA provides transition rules for domestic R&D expenses that were previously capitalized under the old TCJA rules, and options vary depending on the business’s size. Larger businesses cannot amend their 2022–2024 returns to claim immediate expensing; instead, they can elect to deduct their remaining unamortized domestic R&D costs from that period on their 2025 or 2025 and 2026 tax returns.
Eligible small businesses with less than $31 million in average annual gross receipts can elect to apply the new expensing rules retroactively to tax years 2022 through 2024, which will require them to amend prior returns and claim a full deduction. Companies electing the retroactive option need to carefully consider this potential impact, as well as the amount of time, paperwork and cost associated with amending previous returns.
Companies that have had qualified R&D activities can usually claim R&D tax credits on amended returns for the previous three tax years. Organizations in taxable loss positions may be able to claim credits even further back. 37 different states offer their own version of an R&D tax credit to encourage in-state innovation, and some companies are eligible for these additional state benefits.
Bonus depreciation
The OBBBA also created a new 100 percent deduction specifically for qualified production property (QPP), which is ideal for companies looking to expense domestic capital R&D investments to bolster cash flow. Examples may include a pharmaceutical company purchasing a new advanced laboratory for drug development, or a tech firm acquiring a new data center for AI development.
Kevin DeCicco
The new R&D capitalization rules raise several other important questions for forward-looking companies. For instance, how might the increasing use of AI in R&D impact expensing and credits? As more organizations move R&D on-shore to take advantage of these rules, will the domestic R&D resource pipeline come under strain, and how can a company best ensure access to it?
The answers to these questions should become clearer over time, but for now, R&D-intensive companies in the U.S. should take careful, thorough stock of the vast advantages and benefits these rules can bring.
Kevin DeCicco, Managing Tax Partner and Chief Operating Officer, Alpine Mar
