Section 174 is Killing Innovation: A Taxing Tale for R&D

As a pivotal element in the R&D tax credit scheme,  section 174 has become a formidable adversary for businesses - especially smaller entities like Yeti- casting an ominous shadow over their future.

At the heart of these challenges lies the Tax Cuts and Jobs Act of 2017, a contentious legislation that fundamentally transforms the financial landscape of Research and Development (R&D). This decree mandates a significant alteration: businesses are no longer permitted to immediately deduct their R&D costs; instead, they must amortize these expenses over a five-year period.

The consequences of this detrimental act have proven severe for small businesses, resulting in larger tax bills and diminished incentives for essential R&D activities. This stifling effect on creative potential jeopardizes their survival in an intensely competitive global market.

Join us as we take a deep dive into Section 174 and the impact it  is having on the R&D landscape.

Understanding R&D Tax Credits:

R&D tax credits have been a cornerstone of encouraging innovation within the United States since their inception in 1981. These credits serve as an incentive for companies to invest in R&D activities, with a small percentage of the incurred expenses being credited against their tax liabilities. Yeti, like many other businesses, engages in R&D to develop internal products and processes, making them eligible for these credits.

To qualify for R&D tax credits, businesses must pass a four-part test, ensuring that their activities meet the criteria set by the government. The following  While Yeti conducts R&D regularly, the decision to claim these credits often lies with our clients, as they are the entities that assume the risks associated with the innovation process.

The 4-part test under Section 174 outlines the criteria that must be met for expenses to qualify for the R&D tax credit. It’s important to know that, while companies like Yeti conduct R&D regularly, the decision to claim R&D credits lies with their clients, as they are the entities assuming the risks associated with the innovation process.

The criteria for qualifying for R&D tax credits are:

• ‍Permitted Purpose
  ‍The research must be undertaken for the purpose of discovering information that is technological in nature. In other words, the research must be intended to eliminate uncertainty concerning the development or improvement of a business component.‍
• Technological in Nature
  ‍The process of experimentation used to discover information must rely on principles of the physical or biological sciences, engineering, or computer science. The experimentation may involve evaluating various alternatives, performing systematic trial and error, and refining hypotheses.‍
• Elimination of Uncertainty
  ‍The taxpayer must intend to discover information that would eliminate uncertainty concerning the development or improvement of a business component. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the business component.‍
• Process of Experimentation
  ‍Substantially all of the research activities must constitute a process of experimentation. This involves evaluating one or more alternatives in a systematic way to achieve a result, such as the development or improvement of a product or process. The experimentation may include modeling, simulation, trial and error, or other methods.

The Problematic Turn of Events – The Tax Cuts and Jobs Act

Our narrative takes an ominous turn with the introduction of the Tax Cuts and Jobs Act in 2017. Section 174, a seemingly innocuous clause within the act, mandates that businesses cannot immediately expense their R&D costs but must amortize them over five years. This stipulation, intended to curb perceived abuses, has inadvertently turned a once-positive incentive into a deterrent.

To illustrate the conundrum, consider a hypothetical business making $5 million with $4 million in general expenses. Before R&D spending, the company would have a profit of $1 million. However, under Section 174, if the company invests $500,000 in R&D, they can only write off one-fifth of it in the current year. This results in a tax liability based on $900,000, despite only making $500,000 in cash.

The unintended consequences of Section 174 have triggered widespread concerns among businesses, leading to bipartisan efforts to rectify the issue. Unfortunately, despite several bills proposed to amend the section, a resolution has yet to materialize. This delay has left businesses grappling with larger tax bills and reduced incentives for R&D.

The disheartening reality is that, as of now, there is limited recourse for businesses affected by Section 174. Yet, organizations like the Software Small Business Alliance have initiated efforts to raise awareness and garner support for a legislative fix. Individuals and businesses can write letters, sign petitions, engage in advocacy, and reach out to their congressional representatives to express the urgency of addressing this critical issue.

As businesses navigate the intricacies of tax codes and strive for innovation, Section 174 stands as a formidable obstacle. The tale of this taxing provision underscores the importance of continuous dialogue, advocacy, and collective action to ensure that the incentives designed to promote R&D truly fulfill their purpose without unintended repercussions. Until a legislative fix is enacted, businesses must weather the storm and hope for a brighter future for innovation in the United States.