In 2025, many manufacturers are looking forward to favorable enhancements to the federal tax code, including reinstatement of bonus depreciation, continued utilization of Internal Revenue Code (IRC) Section 179D energy efficient commercial building deductions, clarity on the timing of Employee Retention Credit (ERC) refunds and a maturing marketplace for transferable energy credits. However, it is anticipated that there will be no development to the potential reinstatement of the ability to immediately deduct Specified Research or Experimental (SRE) expenditures under IRC Section 174.
Understanding the nuances of the tax rules related to Research and Development (R&D) is crucial for manufacturers and other businesses engaged in innovation. Two sections of the IRC that address R&D expenditures are Section 174 (Amortization of Research and Experimental Expenditures) and Section 41 (Credit for Increasing Research Activities). While these statutory provisions work in tandem and aim to support and incentivize R&D activities, they have distinct roles and implications, which have evolved over time.
The Emergence of Section 174
Section 174, introduced in 1954, was initially designed to enable immediate deductions of all defined research and experimentation (R&E) expenses under Section 174(a), offering a comprehensive approach that encompassed a wide range of direct and indirect costs (onshore and offshore), including wages, supplies, rent, utilities and other overhead costs associated with R&D efforts. This broad definition enabled companies to deduct these expenses from their taxable income, thereby reducing their tax liabilities.
Section 174(b) gave taxpayers the option to elect to capitalize their R&E costs instead of expensing them, which was particularly beneficial for companies in a loss position or startups in pre-revenue or early-revenue because then they could defer initiating a net operating loss (NOL), which is a 20-year carry forward. Dollars spent on payroll, marketing, R&D and/or rent over the amount brought in through sales would be counted as an NOL.
Recent Changes and Implications
Significant changes occurred on January 1, 2022, when certain tax provisions under the Tax Cuts and Jobs Act (TJCA) began to sunset. As a result, for tax years beginning after December 31, 2021, Section 174 required taxpayers to instead capitalize SRE expenditures and then amortize them over either five (domestic) or 15 (foreign) years. This shift meant that businesses could no longer immediately deduct their R&E costs, impacting cash flow and financial planning for many companies.
The Role of Section 41
In contrast, Section 41 specifically addresses the calculation of the Credit for Increasing Research Activities (the R&D Tax Credit) and allows a subset of Section 174 expenditures to be included in a separate general business credit calculation (wages, supplies and contract research expenditures resulting in a dollar-for-dollar reduction in tax liabilities.
Section 41 Qualified Research Expenses (QREs) vs. Section 174
|
Section 41 |
||
|
Onshore |
Offshore |
|
|
Wage QRE (Box 1 W-2 Wages) |
✓ |
X |
|
Supplies QRE |
✓ |
X |
|
Cloud/Rental |
✓ |
X |
|
Contract Research At 65% |
✓ |
X |
|
Amorized Over Five Years |
Amortized Over 15 Years |
|
|
Section 174 |
||
|
Onshore |
Offshore |
|
|
R&D Employee Cost |
✓ |
X |
|
Supply Costs |
✓ |
X |
|
Cloud Research Costs |
✓ |
X |
|
U.S. Contractor Costs At 100% |
✓ |
X |
|
Fringe Benefits |
✓ |
X |
|
Funded R&D |
✓ |
✓ |
|
Foreign R&D Wages |
X |
✓ |
|
Foreign R&D Contractors |
X |
✓ |
|
Depreciation |
✓ |
✓ |
|
Patent/Attorney Fees |
✓ |
✓ |
|
Software Licenses/Data Subscription Costs |
✓ |
✓ |
|
Other Software Development Costs |
✓ |
✓ |
|
General & Administrative Expenses |
✓ |
X |
|
Other Incidental Costs for Development |
✓ |
✓ |
|
Amortized Over Five Years |
Amortized Over 15 Years |
|
Impact on Manufacturers and Other Businesses
The distinction between these two sections has significant implications for businesses, particularly in light of recent changes. While Section 174 now requires capitalization, reducing immediate tax relief, Section 41 continues to offer tax credits for a narrower set of expenses. This duality has led to challenges for manufacturers, especially those in the middle market, who have found themselves capitalizing a large portion of their R&D expenditures without corresponding credit benefits. As a result, some have faced financial strains, potentially affecting their ability to innovate.
With the incoming Republican Administration and GOP-controlled Congress, a reinstatement of the ability to immediately deduct SREs is expected at some point. The timing of such a legislative change is unknown and will depend on the ability to renew many of the Tax Cuts and Jobs Act (TCJA) of 2017 provisions (set to expire after 2025) in the Senate’s budget reconciliation process.
How We Can Help Alleviate the Confusion
Understanding the historical context and differences between IRC Section 174 and Section 41 is critical for businesses engaged in R&D. As companies navigate these provisions, they must adapt their financial strategies to continue fostering innovation while managing their tax obligations effectively. As a result, the calculation of Section 41 should be the starting point in determining the potentially qualifying Section 174 expenditures and should be done concurrently.
While the law is subject to potential change in the future, companies are obligated to assess their tax provisions and estimated tax payments based on the law as it exists now. Cherry Bekaert can help assess current tax opportunities and liabilities under the law as it exists today as well as under any newly enacted legislative provisions.
Your Guide Forward
By leveraging our understanding of tax regulations and the industrial manufacturing industry, Cherry Bekaert is equipped to help companies maximize their R&D tax credit claims, enhance their bottom line, and support their ongoing innovation efforts. Let us help guide you forward.
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