The federal Research and Development (R&D) Tax Credit was originally enacted in 1981 as a temporary measure to boost innovation and the economy. Since then, it’s been amended and expanded, becoming a permanent part of the U.S. tax code in 2015. More changes are on the horizon in 2024, with implications for professional services firms seeking to optimize the credit and reduce income tax liabilities.

The Opportunity for Professional Services Firms

The R&D Tax Credit is aimed at encouraging firms to invest in research and development. In 2022, the definition of research that can qualify for the R&D Tax Credit expanded, making any company that invests in product or process improvement eligible. In addition, the improvements need only to be new to the firm, not the industry. Based on the expanded definition, research and development activities in the professional services sector that contribute to innovation in design or infrastructure, new or improved software platforms, specialized technologies or alternative material testing can qualify for the credit.

Overall, the IRS requires qualifying R&D activities to meet a four-part test:

• Permitted Purpose: The purpose of the research must be to create or improve a product or process, resulting in increased performance, function, reliability or quality.
• Elimination of Uncertainty: You must demonstrate that you’ve attempted to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product design.
• Process of Experimentation: At least 80% of the activities must be elements of a process of experimentation designed to evaluate alternatives for achieving the desired results through confirmation of the hypotheses accomplished by trial and error, testing or modeling, and refining or discarding of the hypotheses.
• Technological in Nature: The activity performed must fundamentally rely on principles of physical science, biological science, computer science or engineering.

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Proposed Changes to the R&D Deductions Under Section 174 & Reporting Requirements on Form 6765

The Tax Relief for American Families and Workers Act of 2024 proposes a delay to the R&D capitalization and amortization requirement under Section 174. The pending legislation would allow qualifying domestic R&D expenses incurred between the end of 2021 and the start of 2026 to be immediately deducted. Currently, U.S.-based research expenses must be amortized over a five-year period.

If the Act is passed, firms that claimed the R&D Tax Credit in their 2022 tax filings would be able to accelerate their Section 174 capitalized balance over the next two years and will be able to immediately deduct their 2023 R&D expenses on their tax return but must file a change in accounting method. (For foreign research costs, the 15-year amortization requirement will stay in place.) The Act is pending Senate approval after being passed by the House of Representatives in early 2024.

Another proposed change impacting firms claiming the R&D Tax Credit comes from the Internal Revenue Service (IRS). The IRS is proposing revisions to Form 6765, the form used to calculate and claim the R&D Tax Credit. The intent behind the changes is to formalize the capture of detailed information listing each business component related to the firm’s R&D projects.

Currently, firms report their total qualified research expenses by category with their filing. However, the revised Form 6765 would require documentation for each business component, including:

• How many business components are included in generating the credit
• Category of the business component (product, process, computer software, technique, formula or invention)
• New categories of expenditures included in the current year
• Documentation of what the research sought to discover and one or more alternatives evaluated during the experimentation phase
• Officer wages included in the qualifying research expenses
• Wages by type of work (supervisory, direct research and support)
• Supplies, rental or lease costs of computers and qualified outside contractors

How to Prepare for the Possible Changes

To optimize the R&D Tax Credit and not leave money on the table, your firm should begin to adjust how it tracks R&D expenses in anticipation of the proposed reporting changes. Professional services firms that are not already tracking the money and time invested in R&D activities at the project and person levels will need to shift to more detailed tracking processes. Ultimately, firms need the ability to track separate research initiatives and the expenses and people resources involved with each.

An expert research and development tax advisor can help you navigate all the pending changes and reporting complexities. They can provide guidance on the implications for past tax filings and any necessary adjustments to current tracking processes.

The professional services industry experts at CBIZ can keep you in the loop as changes to the R&D Tax Credit and Section 174 deductions are implemented. We can also help you identify qualifying R&D activities and optimize the credit for your firm. Connect with a member of our team and gain access to more resources here.

This article includes input from Gary Fujita, Managing Director at CBIZ MHM, LLC and a leader in tax incentives. Gary is a strategic partner for clients, as he advises companies on best practices for tax credits and provides clients with a detailed action plan and control points for the R&D environment.

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