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. However, the R&D deduction is available to even the smallest one-person business that engages in 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 obtain favorable tax treatment, these costs must be incurred to develop or improve a product. Products can include:
- 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.
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 them all in a single year or 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.
Most taxpayers want to deduct as much as they can in a single year, so they elect to treat R&D costs as a current business expense. This enables you deduct the entire amount in the year the costs were incurred. You may take this deduction whether or not you make any money from your research efforts during the tax year. This deduction can be particularly beneficial for start-up businesses because it allows them to deduct R&D expenditures before their business actually begins and before the R&D efforts result in revenue.
Example: Michael, a budding sole proprietor beekeeper, invents a new revolutionary type of beehive. This year he spent $10,000 to develop a prototype and obtain a patent. He may deduct the entire amount this year as an R&D expenditure on his Schedule C, Profit or Loss From Business.
If you don't elect to currently deduct R&D costs in the first year, you must get IRS permission to deduct them later. Also, once you make the election to deduct, you can't change it unless you get IRS approval.
Amortization means you deduct a portion of a cost every year over a period of years. If you elect to amortize your R&D expenses, you deduct them in equal amounts over 60 months or more. The amortization period begins with the month you first receive an economic benefit from the costs.
In order to amortize, the R&D costs:
- must be chargeable to a capital account or an account holding the business's assets (in other words, your business has to pay for the R&D, you can't pay for it from your personal funds)
- must be connected to your trade or business, and
- can't be deducted as current business expenses.
You elect amortization by completing Part VI of Form 4562 and attaching it to your tax return. Once you make the election, it's binding for that year and all later years unless you get permission from the IRS to change it.
Example: Assume that Michael from the above example decides to amortize the $10,000 he spent to develop his new beehive. He deducts the $10,000 over 60 months ($167 per month) starting with the first month he receives an economic benefit from his beehive. If he starts benefitting from the beehive in July through sales or licensing, he’ll get a $1,002 deduction for the year (6 months x $167 = $1,002). He’ll deduct the remaining amount over the next 54 months.
10-Year Write Off
An alternative to amortizing or taking current deductions is the write off method. Here, you write off or deduct a percentage your R&D costs over a 10-year period (120 months), which begins with the tax year in which you paid or incurred the costs. With this method, you don’t have to actually obtain an economic benefit from the R&D costs to take a deduction.
To elect this method, you need to complete Part VI of Form 4562 and attach to your return a separate statement showing:
- your name, address, and taxpayer identification number (TIN), and
- the type of cost and the amount of that cost you're claiming in the election.
Changes Starting in 2022
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 credit. Starting in 2022, taxpayers will no longer be allowed to currently deduct R&D expenditures. Instead, they will 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 will have to 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 is claimed, the deduction is reduced by the amount of the credit. The credit is claimed on IRS Form 6765.