Tax Treatment of Research Expenses: Current Law and Policy Issues

Tax Treatment of Research Expenses: Current Law and Policy Issues

INSIGHTi

Tax Treatment of Research Expenses: Current
Law and Policy Issues
Updated December 19, 2022
Companies are allowed to deduct the ordinary and necessary expenses they pay or incur in determining
their taxable income. Under Section 162(a) of the federal tax code, current expenses (e.g., wages and
salaries) are written off in full in the year when they are paid or incurred; capitalized expenses (e.g., cost
of equipment or patents) are recovered over longer periods under Sections 167 and 168, as the economic
value of the underlying assets lasts longer than one year.
This Insight discusses the current federal tax treatment of expenses companies pay or incur in investing in
research and development (R&D) and some of the policy issues this treatment raises.
Tax Treatment of Research Expenses
Before 1954, the federal tax treatment of business R&D expenses was characterized by numerous
disputes between companies and the Internal Revenue Service (IRS) concerning whether the expenses
should be regarded as current or capitalized.
Congress clarified this treatment in 1954 by creating Section 174. The provision gave companies two
options for recovering their “research and experimental expenses” (REEs). One option was to deduct the
entire amount of such expenses in the year when they were paid or incurred under Section 174(a), a
treatment known as expensing. The second option was to capitalize REEs and amortize them over a
period of five or more years under Section 174(b). Congress added a third option in 2004 when it
established Section 59(e), which allowed companies to amortize REEs over 10 years.
REEs are defined as R&D costs in the “experimental or laboratory sense.” The following expenses
qualify for Section 174 treatment: (1) the wages and salaries of researchers, (2) the cost of materials and
supplies used in qualified research, and (3) the cost of operating and maintaining research facilities (e.g.,
rent, utilities, and property insurance). Excluded from qualified expenses is the cost of equipment and
buildings used to perform research, which must be capitalized and recovered through applicable
depreciation allowances.
Congressional Research Service
https://crsreports.congress.gov
IN11887
CRS INSIGHT
Prepared for Members and
Committees of Congress

Congressional Research Service
2
Impact of P.L. 115-97
Congress made no significant changes to Section 174 until it passed P.L. 115-97, also known as the Tax
Cuts and Jobs Act or TCJA, in 2017. The TCJA repealed the option to expense REEs, effective with tax
years beginning after December 31, 2021. Consequently, companies are now required to capitalize those
costs and amortize them over a minimum of 5 years for domestic research and over a minimum of 15
years for foreign research.
The Joint Committee on Taxation (JCT) estimated in 2017 that repealing REE expensing would yield a
revenue gain of $119.7 billion between FY2022 and FY2027. The gain largely reflected timing
differences in the deduction of REEs under full expensing and five-year amortization.
Economic Implications of Current Law
REE expensing holds several advantages for firms. It lowers the tax burden on returns to R&D
investment, relative to 5-year amortization of REEs. Expensing increases a company’s short-term cash
flow, but at the cost of a reduced cash flow from the same investments in future years. Expensing also
simplifies a firm’s tax accounting.
The loss of REE expensing starting in 2022 reduces a firm’s tax incentive to invest in R&D. From 1981
to 2021, that incentive depended on the combined stimulus effect of Section 174 expensing and the
Section 41 research tax credit.
A widely used measure of an investment’s tax burden is the effective marginal tax rate (EMTR) for its
returns. The rate indicates the share of pretax returns from another dollar of new investment that goes to
pay income taxes on those returns. It takes into account a firm’s top marginal tax rate and any applicable
tax preferences (e.g., credits and exclusions) that affect that rate.
A 2021 analysis by the Tax Policy Center (TPC) illustrated the disincentive effect of switching from REE
expensing to amortization. The authors estimated that corporations claiming the Section 41 federal tax
credit for increases in qualified research expenses under two scenarios would realize an increase in their
EMTR for R&D investments from -48% (with expensing) to -20% with 5-year amortization. They also
calculated that the loss of REE expensing would raise the present-value cost of an additional dollar of
R&D investment from $0.52 (with expensing) to $0.80.
Policy Issues
Numerous companies and lawmakers favor a restoration of IRC Section 174(a) expensing. One concern
behind their stance is that the loss of expensing may incentivize U.S.-based firms to undertake less R&D
in the United States. As the TPC analysis suggested, 5-year REE amortization increases the after-tax cost
of domestic business R&D. Such an increase might be sufficient to convince some U.S. multinational
companies to shift more of their R&D operations to countries with greater tax benefits for R&D
investments. The TCJA tried to discourage such a shift by setting the minimum amortization period for
foreign research expenses at 15 years.
Some argue that a 5-year REE amortization boosts a firm’s incentive to deduct its research expenses as
current expenses under Section 162(a). Although such a practice might be permissible, doing so makes
sense only if a company is planning to not claim the Section 41 research tax credit. One requirement for
claiming the credit is that a company’s research expenses must be eligible for Section 174 treatment.
Deducting those costs under Section 162(a) would appear to fail to meet that requirement.

Congressional Research Service
3
There is support in Congress for reinstating the Section 174 expensing option. In the 117th Congress, H.R.
1304, S. 197, and S. 749 would have permanently extended the option for tax years beginning after
December 31, 2021. Section 138516 of the Build Back Better Act (BBBA), as passed by the House in
2022, would have postponed the expiration date for REE expensing from the end of 2021 to the end of
2025. A more recent option has been to restore REE expensing as part of a tax extenders bill.
One concern with reinstating REE expensing is the short-term revenue cost. The JCT has estimated that
the BBBA provision would result in a foregone revenue loss of $105.9 billion from FY2022 to FY2026.

Author Information

Gary Guenther

Analyst in Public Finance

Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff
to congressional committees and Members of Congress. It operates solely at the behest of and under the direction of
Congress. Information in a CRS Report should not be relied upon for purposes other than public understanding of
information that has been provided by CRS to Members of Congress in connection with CRS’s institutional role.
CRS Reports, as a work of the United States Government, are not subject to copyright protection in the United
States. Any CRS Report may be reproduced and distributed in its entirety without permission from CRS. However,
as a CRS Report may include copyrighted images or material from a third party, you may need to obtain the
permission of the copyright holder if you wish to copy or otherwise use copyrighted material.

IN11887 · VERSION 2 · UPDATED