Review Your Manufacturing Company’s R&E Expenditures

By: Cheryl Lanese

October 30, 2023

Recent changes to the tax treatment of research and experimental (R&E) expenses may affect the tax bills of many manufacturers. Amendments made to the Tax Cuts and Jobs Act (TCJA) enacted impactful changes that took effect in 2022.

Under the TCJA, companies must capitalize R&E expenditures under IRC Section 174 and amortize them over five years (15 years for research conducted outside the United States). In the past, businesses could deduct such expenses immediately. Considering the possible impact of these lost deductions, it may be prudent to examine your R&E expenditures and consider these three tax-cutting measures.

Re-Examine the R&D Credit

Determine whether your manufacturing company’s R&E expenditures qualify for the research credit under IRC Sec. 41 (also known as the “research and development,” or “R&D,” credit). In general, tax credits are more valuable than tax deductions. While both reduce your tax bill, tax deductions decrease your taxable income while tax credits lower your tax bill dollar for dollar.

In 2022, the Inflation Reduction Act (IRA) enhanced the ability of start-up businesses to use research credits to reduce payroll tax liability. The TCJA allows start-ups to claim research credits against up to $250,000 in Social Security tax liabilities if they are less than five years old and have less than $5 million in gross receipts. The IRA allows these businesses to deduct up to $250,000 from their Medicare tax liability.

Not all R&E expenses are eligible for the research credit. Sec. 174 applies to a wide range of expenses, including direct and indirect R&E costs. Sec. 41, on the other hand, is normally confined to direct expenses.

Reclassify R&E Spending

Another approach is to examine your R&E spending to see whether any of them can be categorized as deductible business expenses under IRC Sec. 162. Prior to the TCJA, businesses didn’t have to worry about whether their expenses were deductible under Section 174 or Section 162, because the tax treatment was practically the same. However, choosing the right classification of expenses now makes the difference between capitalizing them and immediately deducting them.

Remember that in order to be eligible for the research credit under the TCJA, an expense must be classified as an R&E expenditure under Sec. 174. As a result, the potential benefits of reclassifying R&E expenses as deductible business expenses must be balanced against the potential loss of research credits.

Consider Buying Software

Another notable shift brought about by the TCJA is the taxation of software development expenditures. Previously, firms could deduct these costs as they were paid or incurred. However, software development costs are now classified as R&E expenses that must be capitalized and amortized under Section 174. Rather than building it in-house, one possible method for mitigating the tax impact of this move is to purchase software, which is instantly deductible as a business expense.

Consult Your Advisor

Capitalizing and amortizing R&E costs can have a major tax impact on your manufacturing company. We can assist you in determining if your R&E expenses are eligible for the research credit or whether you can (and should) reclassify any of them as deductible business expenses. Contact us for help.