Now is the best time for small businesses to look into claiming Research and Development (R&D) tax credits. Why? Because the process is about to get a lot simpler. Today, I am going to talk about the future of the R&D tax credit and why it’s promising.
Now, there are still burdensome provisions of the Tax Cuts and Jobs Act (TCJA) in place, as well as difficult filing procedures and documentation requirements imposed by the Internal Revenue Service (IRS).¹ But Congress may take action this year, so I want to get you up to speed on the state of R&D tax credits and what we can expect moving forward.
Misconceptions and amortization periods have chilled innovation since 2022.
The passage of the TCJA was meant to be a win for small government and lower taxes, but it had the opposite effect on R&D tax credits. Before the TCJA, small businesses could immediately write off R&D costs and receive a direct cash payment equal to the total amount of qualifying expenses. The process was easy until the passage of the TCJA at the start of 2022. Then it got complicated.
Businesses, no matter their size, could no longer claim the credit and be done with it. Instead, they had to amortize R&D costs over a five-year period. Here’s how it currently works.
Businesses are permitted to amortize 10 percent of qualified R&D expenditures during the first year of the five-year amortization period. Over the next four years, they can then amortize 20 percent and 10 percent in the final year. These are all Section 174 requirements.
As you can imagine, the additional paperwork required to claim the R&D credit discouraged its use. In addition, small businesses not directly involved in technology have shied away from the credit.
Most business owners believe that research and development only takes place in laboratories with scientists in lab coats or designated R&D departments. However, the tax definition is much more broad.
R&D tax credits can be claimed under the following circumstances:
- Uncertainty: Can a procedure or action that benefits your business be done at all or better? If the answer is unknown, and the rewards are substantial, then research in that area satisfies the credit.
- Experimentation: Any testing or evaluation of processes for more viable alternatives qualifies.
- Quality: Improvements to the performance and quality of a product that is new or improved.
If it were simplified, a wide range of businesses would be able to easily access its benefits.
More paperwork and requirements stifled innovation.
Then, the IRS stepped in and made the situation worse.
Businesses must precisely identify qualifying expenses and provide adequate documentation showing how these costs meet the requirements under Internal Revenue Code Section 41. Financial records, business records, oral testimony, and technical documents may be used for this purpose.
The IRS also required that the names of the individuals responsible for the credit be listed on Form 7765, among other onerous and nitpicking requirements.²
Fortunately, in June of 2024, the IRS waived the requirement.
Will Congress take action?
Early in 2024, a new tax bill—the Tax Relief for American Families and Workers Act—emerged that, if passed, would reverse these changes. However, progress has been slow, and the outcome is still uncertain.
So, while it’s very difficult to predict what will happen, there are a few potential scenarios:
- The bill becomes law before the tax deadlines of March 15, 2025 (for partnerships and s corporations) or April 15, 2025 (for c corporations and sole proprietorships)
- The bill becomes law after the tax deadline of March 15, 2025 (for partnerships and s corporations) or April 15, 2025 (for c corporations and sole proprietorships)
- The bill doesn’t become law.
If the bill passes, businesses will be able to fully expense US-based R&D costs from the tax year 2024 through the tax year 2025. The requirement to charge US-based R&D expenses to a capital account and amortize them over five years will be delayed until December 31, 2025.
The requirement to amortize non-US R&D expenditures for fifteen years will remain unchanged.
The cost of inaction is the status quo.
If the bill doesn’t pass, section 174 requirements will remain in place. Under current law, U.S. research and experimental expenditures paid or incurred in tax years beginning after December 31, 2021, are required to be amortized over a five-year period. Costs attributable to research or experimentation outside the U.S. must be deducted over a 15-year period.
Where should you go from here?
Administrative burdens and amortization periods should not discourage the exploration of R&D tax credits. Instead, businesses should work with a qualified tax professional before and after investing in research that could be eligible for the credit.
Before you file for R&D tax credits, come see me. Do I like it this way? Certainly not. But that’s the situation as it stands.
Improve processes and eliminate uncertainty.
Schedule a discovery call today if you are unsure whether you qualify for R&D tax credits or need help filing. I can help.
References
- RS sets forth required information for a valid research credit claim for refund | Internal Revenue Service [Internet]. www.irs.gov. 2024 [cited 2024 Aug 18]. Available from: https://www.irs.gov/newsroom/irs-sets-forth-required-information-for-a-valid-research-credit-claim-for-refund
- About Form 6765, Credit for Increasing Research Activities | Internal Revenue Service [Internet]. www.irs.gov. Available from: https://www.irs.gov/forms-pubs/about-form-6765