I’ve covered several aspects of the “One Big Beautiful Bill Act” in the past few months. Today, I’d like to address one of the more misunderstood aspects of the new law: research and development (R&D) expensing. There are tremendous opportunities here, and you should be aware of them. So, here’s what we’re going to cover, from top to bottom:
- What were the rules before the OBBBA?
- How will the new rules change your tax planning strategy?
- Are there specific requirements I can use to determine if my idea qualifies as a deductible R&D expense?
- Activities that qualify for R&D credits and deductions.
- Activities that do not qualify.
- Which actions can you take now to optimize your tax savings?
If you want to skip down and take a look at the list of activities, that’s fine. Be sure to return and get a more complete understanding of the situation before you leave.
What were the rules before the OBBBA?
The OBBBA restored “immediate” R&D expensing for domestic research and development as part of an amendment to Section 174A included in the bill. Okay, so what does “immediate” mean, and what did “immediate” replace?
From 2022 to the signing of the OBBBA, R&D expenses had to be amortized over a five-year period; that means businesses would commit large expenses but only receive ⅕ of the expense in tax deductions in the first year, another ⅕ in the second year, and so on.
Cash flow was a significant issue. It was obvious to everyone in the know that slow-rolling tax relief for ambitious R&D projects was deterring firms from pursuing innovation.
How will the new rules change your tax planning strategy?
As I mentioned above, the previous requirements stipulated that domestic R&D expenses had to be capitalized and amortized over a five-year period. Businesses found themselves in trouble. Many firms were hit with unexpected tax liabilities.
Planning for R&D expenses was a complex process. Firms like ours had to spend time working through those complexities, and, of course, had to charge clients appropriately. Businesses were betting big, waiting for relief, and paying through the nose in the meantime.
Following OBBBA, R&D projects have become far more appealing and simpler to integrate into a tax plan.
New rules have cemented the immediate R&D expensing for domestic research incurred after December 31, 2024, which we’ve covered. That solves the cash flow issue for the most part. Unlike 100% bonus depreciation rules that limit the application of changes to relatively recent purchases, R&D expenses are open for retroactive filing.
Small businesses can retroactively expense R&D costs for 2022-2024 by filing amended returns.
R&D expensing changes come with special relief for small businesses, and that’s good news for your tax plan.
Small businesses with less than $31 million in average annual gross receipts can retroactively deduct previous years’ disallowed R&D expenses beginning after December 31, 2021. My team can help you sort through this. Under the new rules, you can:
- File amended returns for 2022, 2023, and 2024 to claim immediate refunds
- Take catch-up deductions over one or two years starting in 2025
- Choose the most beneficial approach based on your cash flow needs
There are options available for larger businesses as well.
Companies above the $31 million threshold can’t amend prior returns, but they can accelerate remaining amortization from 2022 to 2024 over one or two years starting in 2025.
Keep in mind the distinction between domestic and foreign R&D activities.
Only domestic research and development activities qualify for immediate expensing under the new rules. Foreign R&D expenses must continue to be capitalized and amortized over 15 years, as per Section 174.
For those struggling with cash flow since 2022, when R&D expenses had to be amortized over five years, this is the relief you’ve been looking for. By the end of this article, you’ll know exactly what activities qualify for immediate R&D expensing and how much you could save in tax deductions. You may also find that many of your current business activities already qualify.
The “Uncertainty Test” is a quick way to assess whether a project qualifies as R&D.
For an activity to qualify for R&D treatment, it must involve technical uncertainty about the outcome. If you’re confident about the outcome before you start, it probably doesn’t qualify.
- The activity must be technological in nature
- The activity must involve uncertainty
- The activity must use a process of experimentation
- The activity must be for a permitted purpose
Give them a close read. The points above are used by the Internal Revenue Service (IRS) to assess projects.
The following activities qualify for immediate R&D expenses.
Software development is broadly covered.
Creation of Custom Software
Proprietary systems that your company builds in-house, like mobile apps and shopping platforms, are 100% deductible in the same year you invest in them. This frees your firm up to start building right away.
Notice that I used the word “build.” Design is not software.
Development of Algorithms
Most technical processes can be enhanced by an algorithm to make them faster and/or more efficient. The cost of developing that algorithm is an allowable expense under the new OBBBA R&D rules.
Database Architecture
Data storage and retrieval systems are essential for doing business in the 21st century. With the rapid growth of AI, scarcity is starting to affect the cost of data storage. Thankfully, building your own architecture is now deductible.
API Development
An application programming interface (API) facilitates the transfer of data between two applications. Building an API is a deductible R&D expense your business may want to take advantage of, but remember that a dollar is a dollar.
Testing and Debugging
You’ll want to ensure that those new applications and databases function properly. The cost for testing and debugging them is also deductible. Document your expenses carefully to ensure they don’t get challenged by the IRS.
Innovation in product design and development is eligible and underutilized.
Prototype creation
One of the key steps in developing a new product is to create a physical or digital model to help resolve technical uncertainties. The cost of creating that prototype is considered an R&D expense under OBBBA rules.
Material testing
Experimenting with new substances, compounds, or materials requires financial investment to test their performance. For example, the materials that get destroyed in the process need to get replaced. That’s an R&D expense.
Product enhancement
What worked just a few short years ago might be viewed as outdated today. Spending a few dollars to improve the functionality, efficiency, or performance characteristics of existing products can boost sales, and it’s deductible.
Manufacturing process improvements
Your competitors are developing new production methods, techniques, and processes. If you’re not, your business will fall behind. Upgrades count as R&D expenses, giving you more incentive to do them now.
Quality control improvements
Quality control involves developing more effective testing, monitoring, or inspection systems. Have you done that recently? Making this an R&D expense ensures that your company will produce only top-quality products.
Packaging innovations
Creating new packaging solutions that solve technical or environmental challenges is considered an R&D expense.
Technical problem-solving and process optimization activities qualify for R&D deductions and credits.
System optimization
Making existing processes faster, more efficient, or more reliable through technical innovation falls firmly in the “development” category. The research part of that is determining where the improvements need to be made.
Automation development
Creating processes that reduce manual labor while solving technical challenges counts as R&D; however, other considerations are also involved, such as training current employees to work with the new automated systems.
Integration projects
Software applications don’t always play well with one another. The same goes for manufacturing systems. Launching an integration project to learn how to make these disparate parts fit together falls under the umbrella of R&D.
Performance improvements
Activities to improve techniques like manufacturing, welding, drilling, coating, or finishing processes go under R&D. Think of this category as any activity to make something faster, stronger, and better than it was before.
Equipment modifications
Machinery can be upgraded or phased out if it’s becoming obsolete. The upgrade option is an R&D expense. Depreciation covers the phase-out option. Call my office if you have questions about this.
Projects involving quantitative research and analysis are common and wide open for immediate R&D expensing and deductions.
Feasibility studies with technical components
Studies involving new methodologies or experimental approaches can make your company more competitive. The drawback to these in the past has been the cost. The OBBBA makes that cost deductible.
Patent research and development
Creating patentable innovations through systematic investigation ensures that your competitors don’t duplicate your product offerings. Many companies lose that battle when they can’t afford the patent.
Compliance solution development
Compliance can be a thorn in the side of sales and marketing or a boon to your R&D department. Building systems to meet compliance regulations can be considered a form of technical innovation.
Data analysis innovations
Developing new methods for processing, analyzing, or interpreting data already saves your company a significant amount of money. You can now add to that savings by deducting the R&D expenses incurred during development.
Testing methodology development
Creating new ways to test products, processes, or systems is similar to building data analysis tools. Put this under R&D also.
Activities that do not qualify—don’t skip this.
Routine maintenance
Regular upkeep of existing systems without technical improvement does not count as an R&D expense.
Training and education
General staff development programs that don’t involve creating new knowledge might be deductible, but not under R&D.
Market research without technical innovation
Are you sensing a pattern? Standard consumer surveys or market analysis do not count as innovation.
Administrative improvements
Better filing systems or office layouts that don’t solve technical problems go under “office expenses,” not R&D.
Style, taste, or cosmetic changes
You wouldn’t seriously try to deduct this, would you? Modifications made purely for aesthetic reasons are not R&D projects.
Competitors are scraping the bottom of the barrel for possible R&D expensing.
China offers a 200 percent “super deduction” to its domestic businesses, making a competitive tax code for U.S. manufacturers critical. The OBBBA helps level the playing field by making R&D investment more attractive in the United States. A key element of this is optimizing cash flow. With immediate expensing restored, businesses can:
- Accelerate R&D projects to maximize 2025 deductions
- Improve cash flow through immediate tax benefits
- Reduce the effective cost of innovation by up to 30-40% depending on tax rates
The OBBBA makes immediate expensing a permanent change to the tax law, rather than a limited reprieve, providing businesses with the certainty needed for long-term R&D planning and investment decisions. Whether you’re developing software, improving manufacturing processes, or creating new products, the time to act on this is now.
Identify, classify, and deduct R&D activities as soon as possible.
If you haven’t reviewed your business activities for R&D opportunities, you may be leaving significant tax savings on the table. Begin by examining the checklists above, document your qualifying activities, and schedule a discovery call so we can get on the ball and maximize these new opportunities.
Talk soon,
Jeremy A. Johnson, CPA