OBBBA and Section 174(A): the New R&D Tax Landscape

A Return to Expensing: What’s New with OBBBA and Section 174(A)

For years, businesses invested in innovation faced a growing burden due to the TCJA’s requirement to capitalize and amortize domestic R&E expenses over five years. This policy, which went into effect in 2022, was a departure from long-standing practice and put many companies, particularly startups and those heavily reliant on R&D, at a disadvantage. The OBBBA, enacted in 2025, directly addresses this by introducing Section 174(A), which permanently allows taxpayers to fully deduct domestic R&E expenditures in the year they are incurred. This change is a significant win for U.S. businesses, fostering a more favorable environment for domestic research and development. It immediately boosts cash flow and provides a powerful incentive for continued investment in innovation.

While the OBBBA restores full expensing for domestic R&E, it’s important to note that the rules for foreign R&E expenditures remain consistent with the TCJA. These costs must still be capitalized and amortized over 15 years. Furthermore, Section 174(d) prohibits the immediate recovery of the unamortized basis in foreign capitalized R&E upon disposition, retirement, or abandonment of property after May 12, 2025. This distinction between domestic and foreign R&E may prompt multinational organizations to reevaluate their research locations, potentially encouraging a shift of activities or engagement with U.S.-based contract researchers to leverage the benefits of full expensing.

Software Development and Alternative Approaches

Another area clarified by the new legislation is the treatment of software development costs. Consistent with TCJA Section 174, software development continues to be classified as an R&E expenditure under new Section 174(A)(d)(3). This effectively renders Section 5 of Rev. Proc. 2000-50 obsolete for expenditures incurred in tax years beginning after December 31, 2021. Without new regulatory guidance specifically defining software development activities under Section 174(A)(d), taxpayers are encouraged to refer to interim guidance issued by the IRS (Notice 2023-63, as clarified by Notice 2024-12) for a consistent approach to identification.

The OBBBA also provides flexibility beyond immediate expensing. While Section 174(A)(a) permits immediate deduction, taxpayers have two alternative elections for domestic R&E expenditures:

Section 174(A)(c)

This option allows taxpayers to capitalize domestic R&E (excluding those chargeable to depreciable property) and amortize them ratably over a period of no less than 60 months. The amortization begins in the month the taxpayer first realizes the benefits of the research. This election is made by the due date of the tax return and applies to all subsequent tax years unless consent for a change is obtained.

Section 59(e)

As another alternative, taxpayers can elect to deduct domestic R&E expenditures ratably over 10 years, starting with the year the expenses were made. This is an annual election, offering more short-term flexibility compared to the permanent nature of the Section 174(A)(c) election.

These alternatives are particularly relevant for tax planning. For instance, a company anticipating substantial future income might choose to capitalize and amortize R&E under Section 174(A)(c) or Section 59(e) to match deductions against that higher income. It’s crucial for businesses to carefully model the impact of these choices on various tax calculations, including the business interest limitation under Section 163(j), as amortization deductions are added back when computing adjusted taxable income, potentially leading to a higher limitation. For individuals receiving K-1s from flow-through entities, the Alternative Minimum Tax (AMT) still requires a 10-year amortization of R&E, creating a potential difference that needs to be considered.

Navigating Transition Rules and Procedural Guidance (Rev. Proc. 2025-28)

Implementing these changes involves critical accounting method adjustments. The application of Section 174(A) for domestic R&E is considered a change in method of accounting, generally applied on a cut-off basis for amounts incurred in tax years beginning after December 31, 2024. The IRS, through Rev. Proc. 2025-28, has provided streamlined procedures for this, often allowing a statement in lieu of the more complex Form 3115 for concurrent changes.

For domestic R&E expenses paid or incurred between 2022 and 2024 (when TCJA rules were in effect), taxpayers have crucial transition options. They can either continue to amortize these unamortized amounts over the remaining five-year period or elect to deduct them entirely in the first tax year beginning after December 31, 2024, or ratably over two tax years (e.g., 2025 and 2026). Rev. Proc. 2025-28 clarifies that such deductions are indeed considered amortization for federal income tax purposes, which is vital for other tax calculations like the business interest limitation under Section 163(j). These transition choices, coupled with the ongoing treatment of R&E starting in 2025, require careful consideration, as their combined effects can significantly influence downstream tax outcomes.

Special Considerations for Small Businesses and State Taxes

The OBBBA offers significant relief for small businesses (those with average annual gross receipts of $31 million or less) by allowing them to retroactively apply Section 174(A) to domestic R&E expenditures paid or incurred in tax years beginning after December 31, 2021. Rev. Proc. 2025-28 outlines two primary mechanisms for this:

Small Business OBBBA Election

This involves filing an amended federal tax return (or an AAR for BBA partnerships) for each affected year. The deadline for filing these amended returns or AARs is the earlier of July 6, 2026, or the three-year statute of limitations for credit or refund claims.

Change in Method of Accounting

Small businesses can also retroactively apply Section 174(A) by filing a change in method of accounting.

Crucially, small businesses choosing retroactive application of Section 174(A) must also retroactively apply the conforming amendments to Section 280C(c). This means they must either reduce their domestic R&E expenditures by the amount of their gross research credit or elect to claim a reduced research credit. Rev. Proc. 2025-28 also provides automatic extension relief for certain small businesses that timely filed their 2024 tax returns before September 15, 2025, allowing them to file a superseding return solely to implement these small business-specific provisions by November 15, 2025. This limited window requires immediate action from affected taxpayers.

Beyond federal considerations, state and local tax (SALT) compliance remains a complex area. States have adopted diverse approaches to R&E deductions, with some conforming to the new Section 174(A), others still adhering to TCJA Section 174, and a few even following pre-TCJA rules that allowed full expensing for both domestic and foreign R&E. Taxpayers must meticulously identify which states conform or decouple from the federal changes, evaluate whether state-level elections are available, and anticipate further regulatory guidance from state tax authorities as these significant federal changes ripple through state tax systems.

In conclusion, the OBBBA and the IRS’s subsequent procedural guidance mark a pivotal shift in R&D tax policy. Businesses of all sizes, particularly those with substantial R&E activities, must promptly assess these new provisions, understand the available elections and deadlines, and engage in thorough tax modeling to optimize their strategies and ensure compliance.

Disclaimer: This article provides general information and should not be considered professional financial or tax advice. Please consult with a qualified CPA or financial advisor for guidance specific to your individual business needs.