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Tax Landscape for Research & Experimental (R&E) Expenses

Picture this: Your business is growing quickly, and with that growth comes the opportunity to invest in new projects for future success. You decide to pour resources into research and development for a new product, only to be met with the stark reality that R&D comes with a hefty price tag. Fortunately, your business can get a tax break to help alleviate some of those costs. This is where R&D capitalization comes in. R&D expenses can be either immediately deducted or capitalized and amortized over time to help your business save on taxes. What you decide can impact your tax bill both now and in the future. This article will walk you through the ins and outs of R&D capitalization and how it can help your business save money on its next R&D project.

As a small business owner, understanding R&D capitalization in relation to R&E expenses can be overwhelming. Haven’s accounting services for small businesses can help you grasp how R&D capitalization can impact your finances so you can make the best decision for your business.

What Are R&E Expenses?

Research and Experimental (R&E) expenses, as defined under Internal Revenue Code (IRC) Section 174, are costs incurred in the course of a taxpayer’s trade or business that qualify as research and development (R&D) in the experimental or laboratory sense.

These expenditures are typically associated with efforts to eliminate uncertainty around the development or improvement of a:

Product
Process
Software
Formula
Invention
Technique

Definition Under IRC Section 174

IRC Section 174 defines R&E expenses as costs related to activities intended to resolve uncertainty about the capability, method, or appropriate design of a product or improvement. The key criterion is not the success of the outcome, but whether the activity itself is experimental.

Uncertainty exists when a business does not yet know how to achieve the desired result, whether in terms of performance, methodology, or design. It's the nature and purpose of the work, not the final innovation, that determines eligibility.

Examples of Qualifying R&E Expenses

The IRS and Treasury regulations provide examples of costs that generally qualify under Section 174, including:

Employee wages for staff directly involved in R&D
Materials and supplies used in laboratory or experimental work
Depreciation on equipment used in R&E activities
Legal fees for preparing and filing patent applications
Overhead costs such as utilities, rent, and facility expenses connected to R&D work
Prototype and pilot model development costs
Contract research expenses paid to third parties
Travel and indirect costs are directly related to R&E efforts

Key Changes Under the Tax Cuts and Jobs Act (TCJA)

Prior to 2022, businesses could fully deduct Research and Experimental (R&E) expenses in the year they were incurred, offering immediate tax relief and incentivising investment in innovation.

Beginning in 2022, the Tax Cuts and Jobs Act (TCJA) introduced a significant change: R&E expenses must now be capitalized and amortized rather than deducted upfront.

Specifically, these costs must be amortised over:

Five years for domestic (U.S.-based) research activities
Fifteen years for foreign research activities

How Section 174 Changes Impact Startups and Tech Firms

This shift delays the tax benefit traditionally associated with R&E spending, spreading deductions across multiple years instead of allowing complete, immediate relief. Software development costs are explicitly included in Section 174 and are subject to the exact amortisation requirements, five years if the development is domestic, and 15 years if foreign.

For startups, tech companies, and manufacturing firms, which often invest heavily in research and development (R&D), this change has resulted in higher tax liabilities and reduced cash flow, making it more challenging to sustain innovation-focused efforts.

What the American Innovation and R&D Competitiveness Act of 2025 Proposes

There is ongoing legislative momentum to reverse these rules. The proposed American Innovation and R&D Competitiveness Act of 2025 aims to restore immediate expensing of R&E costs, retroactive to 2022.

If passed, this would ease the financial burden imposed by the TCJA and reinstate the tax environment that previously supported innovation more directly.

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Impact of the New Capitalization Requirement on Businesses

The New Capitalization Requirement: Increased Tax Bills and Cash Flow Challenges

Since 2022, businesses have been required to capitalise and amortise R&E expenses rather than deduct them immediately. These costs must now be spread over five years for domestic activities and 15 years for foreign activities. This shift has significantly increased tax liabilities, even in loss-making years, because companies can no longer fully offset income with immediate deductions.

The loss of upfront expensing has introduced cash flow challenges, forcing businesses to pay taxes earlier without the benefit of the previous tax shield. The impact is especially pronounced for startups and innovation-led companies, which often invest heavily in R&E to fuel growth and maintain competitiveness.

The New Capitalization Requirement and Its Effects on Financial Statements and Tax Accounting

The capitalisation and amortisation requirement under Section 174 affects more than just cash flow; it also has significant implications for financial reporting and tax compliance. It can lead to the creation of deferred tax assets or reductions in deferred tax liabilities, which can complicate tax accounting and potentially increase the effective tax rate.

How Section 174 Changes Affect Deferred Tax Accounting

In some cases, companies may need to establish valuation allowances against deferred tax assets, particularly if future profitability is uncertain. There may also be indirect consequences, such as impacts on interest expense limitations, foreign-derived intangible income (FDII), or other international tax provisions.

To comply with the new rules, many businesses are required to file an accounting method change (Form 3115), which adds further administrative complexity and necessitates careful coordination between the finance and tax teams.

Real-World Business Impacts of the New Capitalization Requirement

Manufacturers and startups have reported significant financial strain due to the increased tax burden and cash flow constraints. Some manufacturers have been forced to lay off workers or seek external financing to maintain operations and fund ongoing R&E projects.

The National Association of Manufacturers (NAM) has highlighted these challenges, emphasizing that the new tax treatment undermines liquidity and growth prospects for innovation-intensive companies.

Comparison with Other Countries’ R&D Tax Incentives

The U.S. policy contrasts sharply with other countries that offer more generous R&D incentives. For example, China allows a 200% deduction for eligible research expenses, effectively doubling the tax benefit for innovation investments.

This disparity may discourage companies from conducting research in the U.S., potentially harming the country’s competitiveness in technology and manufacturing sectors.

Practical Tips for Managing R&E Budgets and Expenses

Establishing a Realistic R&D Budget

Creating a budget is a crucial step in any research and development (R&D) project. To develop a realistic budget, review historical R&D expenditures to understand past spending patterns and trends. Use industry benchmarks to ensure your budget is competitive and aligned with your sector’s norms (often 10-15% of revenue for startups).

Breaking Down the R&D Budget

Once you establish a baseline, break the budget down into clear categories. Allocate funds across personnel, equipment, materials, outsourcing, travel, and contingencies. This granular approach enables close monitoring of spending and identifies areas for cost optimization.

Investing in Talent and Continuous Learning

R&D projects rely on skilled researchers and engineers to achieve their innovation goals. Attracting and retaining this talent is crucial to controlling costs and fostering a culture of innovation, which helps you achieve your objectives.

Both stability and experience help reduce costly turnover and foster innovation. To build a strong team, offer competitive compensation, and encourage continuous learning and professional development opportunities.

Embracing Smart and Flexible Resource Allocation

R&D budgets shouldn’t be static. As innovation projects progress, it’s essential to embrace flexible resource allocation to ensure funds target the most promising initiatives. Use cross-functional teams to leverage diverse expertise and reduce duplication. Maintain agility by reallocating resources as project priorities shift.

Prioritizing Projects with High ROI

Not all R&D projects are created equal. To manage R&D expenses, evaluate projects based on ROI to ensure funding targets efforts with the most significant potential for business success. Consider market demand, potential competitive advantage, and alignment with business goals. Utilize KPIs such as time to market and revenue impact to measure success and keep spending aligned.

Planning for Unforeseen Expenses

Even with careful planning, R&D projects often encounter unexpected costs that can derail budgets and delay innovation goals. To maintain control, include a contingency portion in your budget to cover unforeseen expenses.

Set spending caps and investigate overruns promptly to identify the root cause and maintain financial control.

Aligning R&D Budgets with Company Goals

R&D budgets should support broader business objectives. As such, your R&D strategy must respond to:

Market trends
Striking a balance between innovation ambitions
Operational realities

To that end, establish a clear vision for your R&D program that outlines how it will help the organization achieve its goals.

Balancing Ambitious R&D Projects with Financial Prudence

Managing expectations is crucial for balancing ambitious R&D projects with financial realities. Adopting a commitment vs. wish list approach can help you distinguish between ideal innovation goals and practical financial limits. Prioritize projects based on their strategic importance and feasibility to avoid overextending resources.

Using Data and Benchmarking to Guide Spending

As R&D expenses can strain organizational budgets, it’s critical to ensure your spending level is sustainable. Compare your R&D intensity (spending relative to sales) with peers and industry standards to find a sustainable spending level that supports growth without jeopardizing financial health.

Conducting Post-Project Reviews for Continuous Improvement

Once R&D projects conclude, analyze successes and failures to refine budgeting and project selection processes. This continuous improvement approach will ensure future R&D efforts are more effective and cost-efficient.