Consider the expanded tax benefits for R&D expenses

Many businesses spend substantial funds on research and development of products, services, technologies, and processes. Such R&D costs are a common type of operating expenses for a business. R&D offers companies a way to improve how they do business and what they can offer customers. The industrial, technological, health care, and pharmaceutical sectors typically incur the highest degree of R&D expenses.

Prior to the act, the deductibility of R&D expenses was addressed entirely within Sec. 174. That section refers to the costs as “specified research or experimental expenditures” (SRE expenditures). The definition of such costs is contained in Regs. Sec. 1.174–2. In short, the term means expenditures incurred in connection with a taxpayer’s trade or business that represent R&D costs in an experimental or laboratory sense. SRE expenses could also include costs associated with developing software, as provided in Sec. 174(c)(3).

The act modified certain relevant definitions and made significant changes on both a prospective and retrospective basis. To understand the changes made by the act, some additional background is necessary. Before the TCJA, businesses could fully expense both domestic and foreign R&D. However, beginning with tax years starting after Dec. 31, 2021, a provision in the TCJA eliminated the ability to immediately deduct SRE expenditures under Sec. 174. Instead, businesses were required to capitalize and amortize domestic SRE expenditures over a five–year period and foreign SRE expenditures over a 15–year period. This shift in treatment had a significant impact on many businesses’ bottom line. There were many complaints in both the public and private sector that the mandatory capitalization and amortization significantly reduced the current benefit of incurring significant R&D costs.

With the passage of the act, the mandatory capitalization of all R&D expenses has been repealed. The legislation creates new Sec. 174A, under which taxpayers can deduct R&D expenses in the year incurred or capitalize and amortize them over a period of no less than 60 months. Sec. 174A is effective for expenditures paid or incurred in tax years beginning after Dec. 31, 2024. It is important to note that, while domestic R&D expenditures can now be fully expensed in the year incurred, foreign R&D costs must continue to be capitalized and amortized over a 15–year period.

The act provides that the changes made with the introduction of Sec. 174A will be treated as a change in method of accounting made with the IRS’s consent. These changes are applied on a cutoff basis applying to tax years beginning after Dec. 31, 2024, and no adjustments under Sec. 481(a) are to be made.

In addition to restoring the ability to fully expense domestic R&D expenditures in the year they are paid or incurred, the act also provides some businesses the option to retroactively deduct previously capitalized R&D expenditures incurred in tax years 2022, 2023, and 2024. It is important, however, to realize that to the extent that a Sec. 41 R&D credit is taken on a tax return, the deduction for R&D expenses is reduced by the amount of the credit.

For small businesses, defined as those with average gross receipts of $31 million or less over the prior three years for the first tax year beginning after Dec. 31, 2024 (other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting), the new law provides two options to recover the unamortized portion of previously capitalized domestic R&D expenditures from tax years 2022 through 2024:

• Option 1: Amend previously filed returns for 2022, 2023, and 2024, electing to retroactively apply Sec. 174A, and deduct the remaining unamortized amounts in the year they were paid or incurred.
• Option 2: Deduct any remaining unamortized domestic R&D expenditure amount in tax year 2025, or deduct it ratably over the 2025 and 2026 tax years. This option is considered an accounting method change and requires the filing of Form 3115, Application for Change in Accounting Method, on a cutoff basis.

Option 1 can be great for businesses that want to recover refunds as quickly as possible. The elimination of the Sec. 174 expense deduction had a significant impact on businesses’ tax liability and cash flow. As a result of the change, it was not uncommon for businesses to incur tax liabilities higher than expected due to the fact that R&D expenses were required to be amortized. Option 2 is good if businesses would like to avoid the administrative burden of amending returns. If the entity taking the R&D deduction is a partnership or an S corporation, the owners’ returns must be amended to receive the benefit of the additional deduction. In addition, filing an amended return gives the IRS another opportunity to examine it.

Example:  Impact of the retroactive change: ABC meets the requirements to be a “small business.” In 2024, the company incurred $3 million in qualified domestic R&D expenses. On the company’s 2024 tax return, an amortization deduction of $600,000 ($3 million divided by five years) was taken to reduce taxable income. Under the act, the business can now retroactively elect to fully expense its R&D in 2024 by amending its 2024 tax return and claiming a deduction for the entire $3 million expense.

Under the facts in Example, if ABC were not a small business, it could elect to deduct its remaining unamortized domestic R&D expenditure amount of $2,400,000 from 2024 in 2025, or over two years, 2025 and 2026. However, making this election will be considered a change in accounting method, and filing Form 3115 on a cutoff basis will be required. As a result, there will not be an annual adjustment to income under Sec. 481(a).

On Aug. 28, 2025, the IRS issued Rev. Proc. 2025–28, which contains much guidance on taking advantage of the new rules with regard to R&D expenditures. The revenue procedure’s details are beyond the scope of this article. However, one item of note is that if a small business is amending prior–period returns to take advantage of the deductibility of these expenses, the returns must be filed by the earlier of July 6, 2026, or the due date for filing a claim for credit or refund (the date that is three years from the time the return was filed).

It is clear that the new favorable treatment of R&D is a strategic opportunity for businesses that invest in innovation.