As the 2022 tax year wraps up, a major new restriction is now in place for businesses looking to deduct research and experimental (R&E) expenses in the U.S.
With the new capitalization rules under Internal Revenue Code Section 174, businesses can no longer deduct all R&E expenses in the year they’re incurred, starting December 31, 2021. Instead, companies must now capitalize and amortize their annual R&E spending going forward.
The bottom line? Most businesses will see a significant increase in taxable income for 2022.
What does this mean in practice? In short, it’s complicated.
First, it’s important to note that these Section 174 changes are separate from the Section 41 R&D tax credit. In fact, since the Section 174 changes will increase taxable income for companies of all sizes, Section 41 will become even more valuable to help reduce your 2022 tax bill—especially for innovative startups and founders.
Historically, Section 174 had a much broader definition of R&E than Section 41, covering things like legal fees and utilities as eligible expenses that could be deducted. (For more on what qualifies for R&D, check out our calculator) Companies often used both Section 174 and Section 41 to manage costs and extend their runway. This approach has been a key tax strategy for businesses of all sizes since Section 174 was introduced in 1954—and a powerful way to support innovation in the U.S.
However, the December 2017 Tax Cuts and Jobs Act (TCJA) expanded what counts as R&E starting in 2022, but also made it much harder for companies to use R&E deductions to offset expenses. The impact? Many businesses will now face taxable income—even those that have never reported taxable income before.
The new rules also set different requirements for amortizing R&E expenses based on location. Domestic R&E expenses must be amortized over 5 years, while foreign R&E investments must be spread over 15 years. On top of that, expenses are considered “placed in service” at the midpoint of the first year, so your first-year deduction is only about half of what it will be in later years.
Another challenge for innovative startups: The TCJA also changed how software development costs are handled. Now, any costs paid or incurred for software development—whether for internal or external use—must be treated as R&E expenses and capitalized starting in 2022.
The big question: Why?
Despite pushback from business owners, tax professionals, and even many members of Congress, these new amendments to Section 174 went into effect for 2022 without changes. This is especially frustrating for many, since it’s widely seen as a move that makes the U.S. less competitive globally.
The 2017 TCJA was passed during a highly polarized time in U.S. politics, with Republicans pushing to cut taxes for corporations and high earners. The bill included many compromises and provisions that weren’t expected to take effect—especially as political priorities shifted in the years since.
Without getting too deep into politics, the reality is that many businesses and tax professionals spent years waiting and lobbying for lawmakers to pause or repeal changes to Section 174. But those changes never came. While Congress could still allow businesses to use R&E deductions for 2022 retroactively, tax preparers need to follow the current IRS rules as the March and April deadlines approach.
What does this mean for your next tax return?
For many companies, this is uncharted territory. Businesses that previously used Section 174 deductions before the TCJA often didn’t track Section 174 expenses separately under the new rules. With the new amortization guidelines—including the mid-year convention—the amount owed for 2022 could jump by double-digit percentages compared to 2021.
The silver lining? Now that more businesses must report higher taxable income—or taxable income for the first time—the Section 41 R&D tax credit is more valuable than ever to help offset what you owe. Plus, your R&D tax credit study is a great starting point for identifying your Section 174 expenses, since all Section 41 expenses also count as Section 174 expenses.
At Boast, we help innovative businesses identify and quantify all available R&D activities and expenses that can qualify for tax credits to not only minimize the impact on their annual tax bills, but extend their runway in the face of a rocky financing landscape.
To learn how your team can develop an R&D Capital Strategy that accounts for the new Section 174 requirements, existing R&D tax credits, and how to plan for the year ahead, join our weekly #InnovatorsLive event on LinkedIn every Friday at 12pm ET/9am PT.
