The complexity and confusion are only compounded by pending legislation. On January 31, HR 7024 was passed by the U.S. House of Representatives, by a vote of 357-70. A portion of this bill includes the repeal of Section 174; however, the likelihood of its passage is slim. At the base of all businesses is innovation and growth strategies; for most companies, R&D is their bedrock. In the United States, to help spawn innovation as part of the Economic Recovery and Tax Act of 1981, the Research & Experimentation Tax Credit was introduced. Although it was initially supposed to last three years as a specific incentive to encourage companies to invest in R&D, Congress recognized its value in helping businesses create more products and services.
The definition of research and development or experimental expenditures is quite broad, making it a challenge for most businesses to determine how to categorize or re-categorize expenses that might be related to research. However, in September 2023, the Internal Revenue Service provided more guidance that addressed several issues, including the definition of software and the treatment of research performed under contract. For instance, technology or software companies may face significant increases in their taxable income because they are no longer allowed to deduct certain expenses, as all costs incurred in connection with software development must now be amortized.
It is worth noting what situations or conditions are not covered or are explicitly excluded from the definition of R&D for the Section 174 tax benefit. These exclusions include market research, advertising, and sales promotions; research after commercial production of a product has begun; quality-control testing; research funded by another party in which the taxpayer does not retain substantial rights; and any research conducted entirely outside of the United States.
For businesses, the ability to deduct R&D expenditures under Section 174 can significantly reduce taxable income. Section 174 requires companies to document their R&D activities carefully and ensure that expenditures qualify for the specific deductions, including maintaining records that demonstrate how the expenses directly relate to qualified research activities. Not surprisingly, the expansive nature of this kind of work requires that corporate tax departments do their best to leverage technology to ensure proper compliance with the tax code. Given this, it is not surprising that a few years ago, a group of chief financial officers reported that they weren’t confident that their companies were taking full advantage of all the R&D credits to which the companies were entitled, citing the difficulty in accessing specific information to support proper claims.
