New or improved products don’t appear out of thin air. Businesses must spend time and money on research and development (R&D) to create them. It can take years for R&D expenditures, which can be substantial, to result in marketable products.
As an incentive for businesses to keep investing in R&D, the tax law provides favorable tax treatment for research and experimental costs. In most cases, you can currently deduct these costs or deduct them over five or ten years.
The words “R&D expenditures” often conjure up images of huge corporations that spend millions to develop new products in massive laboratories or research centers. But the R&D deduction is available to even the smallest one-person business that engages in the research and development of new products.
What Are R&D Costs?
"R&D costs" are the reasonable costs you incur trying to figure out how to create or improve something in the experimental or laboratory sense. In IRS jargon, they are costs for trying to obtain the information you need to eliminate uncertainty about creating or improving a product. Uncertainty exists when the existing information you have doesn't show you how to design, make, or improve the product. You can deduct R&D costs whether or not they result in a product that is ultimately sold or used in your business.
To get favorable tax treatment, these costs must be incurred to develop or improve a product. Products can include:
- formulas
- inventions
- pilot models
- computer software, and
- processes and techniques.
You can deduct expenses like salaries, supplies and materials, operating costs, and the costs of obtaining a patent from the U.S. Patent & Trademark Office, including attorneys' fees paid to file a patent application. You can also deduct the cost of hiring someone else to perform R&D on your behalf, such as an outside contractor, engineering firm, or research institute.
Generally, long-term assets like equipment, machinery, or real estate are not deductible as R&D expenses. Instead, you depreciate, expense, or otherwise deduct the cost of such items the same as any other long-term asset.
R&D expenses also don't include costs for:
- advertising or promotions for products
- quality control testing
- consumer surveys
- management or efficiency studies
- research for literary, historical, or similar projects, or
- acquiring someone else's patent, production, or process.
Once your uncertainty ends, and the new or improved product is developed, your R&D expenses end. In other words, you can't deduct production costs for a product as R&D costs.
Tax Options
Under regular tax rules, R&D costs are capital expenses and aren't deductible until the research project is abandoned or deemed worthless. However, if your R&D costs qualify for special tax treatment, you have the option of deducting the cost a portion at a time over several years through amortization or a write-off. You have to tell the IRS how you're going to treat your R&D costs by making an election on your tax return. The rules differ for R&D costs incurred before 2022 and those incurred during 2022 and later.
R&D Costs Incurred 2021 and Earlier
Before 2022, a taxpayer had several choices for how to treat research and experimental expenditures:
- deduct them
- amortize them over a period of at least 60 months
- elect to amortize them over a 10-year period, or
- capitalize them by failing to deduct or amortize them.
Most taxpayers wanted to deduct as much as they could in a single year, so they elected to treat pre-2022 R&D costs as a current business expense. This enabled them to deduct the entire amount in the year the costs were incurred. This deduction could be claimed whether or not the business made any money from its research efforts during the tax year. This deduction was often particularly beneficial for start-up businesses because it allowed them to deduct R&D expenditures before their business actually began and before the R&D efforts resulted in revenue. If you didn't elect to currently deduct pre-2022 R&D costs in the first year, you must get IRS permission to deduct them later. Also, once you made the election to deduct, you can't change it unless you get IRS approval.
Instead of deducting pre-2022 R&D expenses, you could elect to amortize them—that is, deduct them in equal amounts over 60 months or more. The amortization period began with the month you first received an economic benefit from the costs. The election was limited to R&D expenses that:
- were paid or incurred before 2022
- were not treated as currently deductible expenses, and
- were chargeable to a capital account but not chargeable to property that was subject to an allowance for depreciation or depletion.
An alternative to amortizing or taking current deductions was the write off method. Here, you wrote off or deducted a percentage of your R&D costs over a 10-year period (120 months), which began with the tax year in which you paid or incurred the costs. With this method, you didn't have to actually obtain an economic benefit from the R&D costs to take a deduction.
R&D Costs Incurred 2022 and Later
The Tax Cuts and Jobs Act (TCJA), the massive tax reform law that took effect in 2018, made some big changes in the R&D tax deduction. Starting in 2022, taxpayers are no longer allowed to currently deduct R&D expenditures. Instead, they have to amortize (deduct) them over five tax years, beginning with the midpoint of the tax year in which the specified research or experimental expenditures are paid or incurred. R&D expenses incurred outside the United States must be deducted over 15 years.
Tax Credit for R&D Expenses
In addition to a tax deduction for R&D expenses, a tax credit is available. Unlike a deduction, which only reduces taxable income, a tax credit is a dollar-for-dollar reduction in the amount of tax that must be paid. The R&D credit is complex. The amount of the credit is based on how much a taxpayer has increased its R&D expenses over a base period. Small businesses and start-up companies typically claim an alternative simplified credit. With this method, their credit is equal to 14% of the amount current-year R&D expenses exceed 50% of the average spent in the previous three years.
Small and start-up businesses also have the option of applying the credit to offset their Social Security payroll tax payments instead of their income taxes. Up to $250,000 per year in Social Security payments for up to five years can be offset with the credit. This option is available only for businesses with less than $5 million in gross receipts and with no more than five years of gross receipts.
If both the R&D credit and tax deduction are claimed, the deduction is reduced by the amount of the credit. The credit is claimed on IRS Form 6765.