How to Navigate the Changes to R&E Tax Treatment

The Tax Cuts and Jobs Act (TCJA) introduced a major—though delayed—shift in the tax treatment of research and experimentation (R&E) expenses under IRC Section 174. Despite expectations, Congress did not act before these changes took effect in 2022, and manufacturers are feeling the financial strain.

The National Association of Manufacturers (NAM) has been vocal about the challenges its members, especially small and medium-sized manufacturers, are experiencing due to the new R&E tax treatment. Here’s an overview of the current rules, how manufacturers are impacted, and some strategies for potentially mitigating these tax effects.

The New R&E Tax Treatment

Prior to the TCJA, businesses could deduct R&E costs in the year they were incurred or capitalize and amortize them over at least five years. Software development expenses could be deducted immediately, amortized over five years from project completion, or amortized over three years once put into service.

Under the new rule, R&E expenses incurred in the U.S. must be amortized over five years, while those incurred abroad are subject to a 15-year amortization period. Software development costs are now treated as Section 174 expenses and are subject to these same amortization rules.

The result has been higher tax bills for many manufacturers, with some facing tax obligations even in loss years. This unexpected burden has reduced cash flow, forcing some to lay off workers or seek financing. NAM has raised concerns about the U.S. falling behind on tax policies supporting R&E, pointing out that other countries, like China, provide generous R&E deductions to encourage innovation.

Strategies to Mitigate Tax Impacts

Despite the challenges, manufacturers have options to reduce the impact of these tax changes:

- Claim the Research Tax Credit: If you’re not already taking advantage of the research tax credit under IRC Section 41, consider evaluating your eligibility. This credit isn’t limited to technology companies; manufacturers developing new processes, products, or techniques may qualify. The research credit is typically 6-10% of qualified research expenses, including wages, supplies, and contract research expenses. Exploring both past and present eligibility could reveal valuable tax savings, especially as more manufacturers incorporate advanced technologies.

- Use Accelerated Depreciation: You may be able to offset the impact of R&E amortization through accelerated depreciation. For instance, if you’ve been depreciating your property over the standard 39-year period, a cost segregation study can identify which assets can be depreciated over shorter periods, like five, seven, or 15 years. Even if property has been in service for years, you may still be able to claim depreciation missed in prior years, with some assets qualifying for bonus depreciation.

- Review Asset Recovery Periods: Check the recovery periods for items in your fixed asset ledger. Some assets with shorter useful lives may have mistakenly been depreciated over the longer 39-year period.

- Reclassify R&E Expenditures as Business Expenses: Re-evaluate your R&E expenditures to see if any could be properly classified as IRC Section 162 business expenses, which may qualify for immediate deduction rather than amortization.

Looking Ahead

This year, the House of Representatives passed a measure to reinstate immediate expensing for R&E costs, but the Senate blocked it due to an unrelated Child Tax Credit provision. Regardless of election outcomes, Congress is expected to address tax legislation in 2025 as many TCJA provisions are set to expire. Keep an eye on any upcoming legislation that may include a fix for Section 174.