If your development team needs help executing research and development (R&D) strategies without negatively affecting your company's financial picture, it's time to examine the concepts of R&D capitalization. Even if you didn't go to accounting school, understanding the benefits and principles behind R&D capitalization can help you navigate the financial waters.

Rather than immediately writing off costs, companies that practice R&D capitalization view these costs as assets instead of expenses. We'll walk through why you might need R&D capitalization, how it works, and what you, as a technical leader, can do to help mitigate potential adverse effects.

Key takeaways:

• The 2017 Tax Cuts and Jobs Act (TCJA) resulted in changes to the treatment of research or experimental (R&E) expenditures under Section 174.

• For tax years beginning after December 31, 2021, companies are required to capitalize and amortize their R&D costs. 

• These costs must be amortized over a period of five years if incurred within the U.S., and 15 years if incurred outside the U.S.

Table of contents:

• What is R&D capitalization?

• How does R&D capitalization work?

• Mitigating the effects of TCJA changes with R&D capitalization  

• How to benefit from the R&D tax credit

• What R&D expenses should your team capitalize?

Prior to 2022, teams could deduct full R&D costs—also known as research and expenditure costs in the tax code—on their tax return. The 2017 Tax Cuts and Jobs Act (TCJA) put a stop to this practice. As of January 1, 2022, companies are required to capitalize and amortize the cost of research and development—including software development costs. 

Rather than immediately deducting R&D costs in the same fiscal year, your team must spread those costs out across five or 15 years—five years for R&D expenditures incurred within the U.S. and 15 years for R&D expenditures incurred abroad.

You may hear the concept of software capitalization spoken of similarly; however, R&D and software capitalization are different concepts. While software capitalization is more broad, R&D capitalization is focused purely on research and development costs and carries more restrictive criteria.

However, recent developments may retroactively delay this change. The Tax Relief for American Families and Workers Act, introduced in January 2024, would allow businesses to fully expense R&D costs until December 31, 2025. This is only applicable for tax years beginning after December 31, 2021. As of December 2024, the bill has yet to become law but has passed the House of Representatives.

If the law passes, businesses can amend returns filed in 2022. Capitalization and amortization over 15 years will still be required for R&D expenses incurred outside of the United States. 

Note: There’s no change to the generally accepted accounting principles (GAAP). R&D will continue to be expensed in companies’ financial reporting statements.

To better understand how R&D capitalization affects your team’s financial picture and IT budget, let’s walk through an example. 

Let’s say your company has $1 million in revenue. In creating a new product, you incur $1.5 million in R&D expenditures. Prior to the 2017 TCJA, your R&D costs would have resulted in a $500,000 tax loss and no tax would have been paid.

For tax years beginning after December 31, 2021, that $1.5 million of R&D expenditures must be capitalized and amortized over five years (assuming expenses were incurred within the U.S.). This results in a $300,000 tax deduction against $1 million of tax revenue that would result in $700,000 in taxable income for the year. At a federal tax rate of 21%, that’s almost a $150,000 tax liability for the year. 

In summary, your company would have brought in $1 million in revenue and expended $1.5 million. You lost money. In addition to that, you would also owe almost $150,000 of tax liability due in April of the next year. 

As you can see, the changes to R&D cost capitalization result in a phantom income increase. Amortization may cause companies in a loss situation to become taxable. Teams with large investments in R&D and no taxable income may struggle to come up with funds to cover the income tax resulting from the TCJA change. 

Federal tax law is an ever-changing beast. For more information on how capitalizing development costs will impact your team’s finances or how to proceed should new tax bills pass, we recommend consulting a seasoned tax expert.

Luckily, it’s not all doom and gloom. There is a way to help offset some of the effects of the TCJA changes. Cue: the R&D tax credit. 

The R&D tax credit is not impacted by the capitalization changes that took place in January 2022. R&D capitalization and the R&D tax credit are governed by two completely different code sections within the IRS. 

For a bit of background, the federal R&D tax credit was created by Congress in the 1980s. The intent behind the credit was to incentivize and reward companies for keeping their R&D efforts here in the U.S. 

If you’re a traditional federal income taxpayer, the R&D tax credit will offset your federal income tax dollar for dollar. If you’re a qualified small business—aka startups that have not yet exceeded $5 million in revenue—you can use those R&D credits to offset your payroll taxes. 

In addition to this federal R&D credit, there are also state-level R&D credits to explore. There are about 30-35 states (it changes every year based on state budgets) that offer their own R&D credit.

As is the case with most everything tax-related, receiving the R&D credit for your company requires some legwork. The IRS requires companies that claim an R&D credit to include specific and detailed information about their eligibility for the credit. 

At a minimum, companies must identify all business components related to the R&D credit for that year. These activities are known as qualified research expenditures, or QREs.

For each specific business component, you must: 

• Identify all R&D activities performed

• Identify the name, title, or position of the team member who performed each R&D activity

• Identify all the information each team member sought to discover through R&D activities

To help ensure your SRE expenditures qualify for tax credits, companies can run them through the R&D four-part test. 

Permitted purpose: The purpose of the activity must develop or improve the functionality, performance, reliability, or quality of a new or existing business component.  

Eliminating uncertainty: Activities must aim to eliminate technological uncertainty about the development or improvement of a product. 

Technological in nature: Activities must rely on the principles of engineering, physical or biological science, or computer science. 

Process of experimentation: Activities must include a process of experimentation, including testing, modeling, simulating, and systematic trial and error. 

From a high level, this test ensures the activities were technological in nature and intended to create a new or improved business component. In developing that new business component, your team had to encounter technical uncertainties and a process of experimentation. If it meets all four requirements, that associated activity qualifies for the credit.

SRE expenditures are broadly defined under Section 174 of the tax code as “all costs incident to the development or improvement of a product, a component of a product, or subcomponent of a product.”

Some examples of costs eligible for capitalization include:

• Patent costs
• Software development costs 
• Labor costs (other than severance compensation)
• Materials and supplies costs 
• Cost recovery allowances 
• Travel costs 
• Operation and management costs

R&D expenses include costs incidental to the development or improvement of a product regardless of whether costs result in a product meant to be used internally or sold. 

Some expenses not considered under Section 174 include: 

• General and administrative service department costs 
• Interest on debt to finance SRE activities
• Costs to register a website domain name or trademark
• Costs to add content to a website 
• Amortization amounts for SRE expenditures 
• Research done outside the U.S.
• Acquiring an existing patent, model, production, or process 
• Acquiring depletable property
• Testing or quality control 
• Consumer or efficiency survey
• Management studies
• Advertising or promotions
• Research for a literary, historical, or similar project

There is often confusion around what’s considered a software development cost. Here are some examples of software development costs eligible for capitalization:

• Software engineering, user experience (UX) design, and related project planning
• Software deployment
• Software coding
• Architecture and user interface (UI) design
• Software support and maintenance
• Quality assurance related to software development
• Software packages or subscriptions used in development

There are two types of software to note for R&D capitalization: internal and external. Due to different accounting standards, making the distinction will allow your accounting department to create more accurate final reports, better inform stakeholders, and avoid potential tax liabilities. Here are the differences between the two types of software:

• Internal software: This software is developed solely for a company's internal use. Capitalization begins later in development when funding is committed and feasibility requirements are met. When the software is complete and placed into service, the capitalization period ends (ASC 350-40).
• External software: This software is developed for sale, lease, or licensing to external parties. Capitalization begins during the planning and design phases. When the software has achieved technological feasibility and is available for general release to customers, the capitalization period ends (ASC 985-20).

It’s important to note that Notice 2024-12 from the IRS, which provides the most recent guidance on Section 174, outlines the rules regarding the capitalization of payments to third-party contract researchers for qualifying activities. If a contract researcher is paid for research—regardless of the outcome—they typically don’t need to capitalize their costs. However, they must capitalize expenses if:

• They bear financial risk 
• Their compensation depends on research results 
• They have the right to use or exploit research results 

Documenting exactly where your team’s R&D costs are going is no simple feat. Pluralsight Flow’s Investment Profile feature is designed to help companies capitalize on their R&D expenses; it helps organizations visualize where resources and time are going. 

Investment Profile comes auto-configured so you can immediately review historical data to better understand prior investments, and is fully customizable to meet the requirements of your organization. 

Ready to learn more? Schedule a demo to see how Flow can help.