Congress is taking its time on reversing delayed tax deductions for innovation.
OPINION
American manufacturers are closely monitoring Congressional attempts to reverse recent adverse changes to IRS Section 174, which is preventing American businesses from fully deducting their R&D costs in a timely fashion. Section 174 is the code section that dictates how certain research expenditures are treated for tax purposes.
For countless businesses, 174 has resulted in six- or seven-figure increases in their tax liability beginning in 2022. The House of Representatives recently acted to provide relief, but it now appears momentum has slowed in the Senate.
If left uncorrected, the result will be a blow to America’s competitiveness in the innovation space, but also financially devastating to the small- to mid-size businesses (SMBs) that are the bedrock of our economy. As the employers of half of the American workforce, SMBs are critical to the prosperity of American families and communities across the nation. Without the support that R&D incentives provide to these enterprises, many will fall to competition from foreign businesses and corporate behemoths.
With all that is hanging in the balance, Congress has a strong opportunity to bring one home for the American taxpayer. Below we will explore how our lawmakers are on the precipice of ushering in the next era of innovation in the manufacturing industry.
A Bit of History
Expenses related to research & development, which range from patent attorney fees to prototype materials costs, are subject to Section 174. For the past seven decades, manufacturers had the option to fully deduct these costs in the year they were incurred. Then in 2022, Congress changed the tax rules and required these deductions to be spread out over five years.
This led to increased tax burdens for many small businesses. As tax bills ballooned, these businesses were left with few options to make cuts to departments such as design, production or quality control. Instead, they were forced to de-prioritize future investment in their own enterprises or even take out personal loans. In contrast, larger corporations barely felt the effects of this legislation, given the laundry list of mitigating mechanisms available to them: bigger balance sheets, access to better credit and access to capital markets, for starters.
SMBs affected by this legislation perform a myriad of indispensable functions typically attributed to “the government.” Private firms develop new materials and manufacturing techniques that are used in our miliary. Engineering firms design planes and equipment for our military that keep our people safe around the world. Electronics manufacturers create chips domestically so we don’t have to use those created by foreign competitors.
Any legislation detrimental to SMBs’ innovation doesn’t only hurt their competitiveness – it threatens our nation’s security, both economic and existential.
The Sun Also Rises
Most House and Senate members already agree that 174 amortization undercuts R&D and would like to eliminate it. Hope is in sight, as in January the House passed a fix to 174 by an overwhelming 357-70 vote, and leaders on both sides of the aisle in the Senate favor restoring the ability of business taxpayers to expense costs in the current year.
Full expensing also serves as a power-up to the R&D credit, which is the most powerful tax credit available to American businesses today. When 174 amortization took effect, many businesses used the R&D credit to mitigate the effects. Business taxpayers are able to go back as far as tax year 2020 to claim the credit, but time is running out. Now more than ever, every business needs to re-evaluate the credit as a means of access to needed capital and to offset any increased tax liability. As the most powerful permanent tax credit available to manufacturers, it rewards companies engaged in a wide range of activities such as:
- Development of new or improved products
- Design of production or testing processes
- Software/firmware development
Additionally, today’s increasing focus on artificial intelligence (AI) and automation in the manufacturing sector provides plenty of opportunity to claim these valuable credits. For example, manufacturers can capture costs for the development of smarter production machinery that takes over repetitive tasks. They can also benefit from developing processes that use AI-based supply chain optimization or predictive maintenance.
The automation efforts incentivized by the R&D credit will help address the shortage of technical workers in the U.S. and enable them to focus on less repetitive and more fulfilling activities. Moreover, the credit can lead to financing additional jobs for programmers and engineers, among others. Finally, manufacturers can claim the R&D credit not just for employees directly engaged in R&D, but also those supporting or supervising these efforts.
