State responses to federal changes to Sec. 174

Editor: Greg A. Fairbanks, J.D., LL.M.

Recent changes to the treatment of research and experimental (R&E) expenditures for federal income tax purposes beginning with the 2022 tax year are having a significant impact on state and local income tax calculations. Under Sec. 174, taxpayers traditionally were allowed the option to currently deduct R&E expenditures or treat such expenditures as deferred expenses to be capitalized and amortized over their life. The law known as the Tax Cuts and Jobs Act of 2017 (TCJA), P.L. 115-97, eliminated the option to take a current deduction. For amounts paid or incurred in tax years beginning in 2022 and after, all taxpayers are required to capitalize R&E expenditures over a five-year period for domestic expenses and 15 years for foreign expenses. This change also affects the application of Sec. 280C(c), relating to the interaction between a taxpayer’s R&E deduction and the research and development (R&D) tax credit.

Despite discussions to delay or repeal the new capitalization and amortization requirements under Sec. 174, efforts to pass such legislation have stalled in Congress as of this writing. The absence of federal action and the prospective effective date created state income tax uncertainty for purposes of determining whether a state conforms to the federal changes to Sec. 174. This conformity analysis is further complicated by several states having enacted legislation during 2022 and 2023 to decouple from current Sec. 174 and allow R&E expenditures to be deducted in the year in which they are incurred. This item discusses the factors that should be considered in determining a state’s conformity to Sec. 174 as amended by the TCJA and reviews recently enacted state legislation in response to this federal provision.

Summary of Sec. 174

Sec. 174 applies to expenditures incurred in connection with a taxpayer’s trade or business that represent R&D costs in the experimental or laboratory sense. The provision also applies to expenditures related to activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish: (1) the capability of developing or improving a product; (2) the methodology of developing or improving a product; or (3) the appropriate design of the product. Sec. 174 generally includes all costs incident to the development or improvement of a product to be used by the taxpayer in its trade or business or to be held for sale, lease, or license (Regs. Secs. 1.174-2(a)(1) and (3)).

As amended by the TCJA, for tax years beginning after Dec. 31, 2021, taxpayers are required to capitalize and amortize all R&E expenditures regardless of how such expenditures were treated previously. Sec. 174 expenditures must be capitalized and amortized as follows: (1) over five years for R&E performed in the United States and (2) over 15 years for R&E performed outside the United States (or Puerto Rico or any U.S. possession). Under this provision, the R&E expenditures must continue to be amortized even in instances where the taxpayer retires, abandons, or disposes of the property related to them. Also, Sec. 174 specifically includes rules governing the treatment of software development. Any amount paid or incurred in connection with the development of software is treated as an R&E expenditure (Sec. 174(c)(3)).

Differences in state conformity to current Sec. 174

For purposes of calculating state corporate income tax liability, states generally use a measure of federal taxable income as a starting point, typically derived either by applying the version of the IRC currently in effect (“rolling” conformity) or the IRC as of a certain date (“static,” or “fixed” conformity). States that adopt significant portions of the current IRC on a rolling basis generally conform to the post-2021 R&E expenditure rules in Sec. 174 unless they specifically decouple from this federal provision. In contrast, certain states adopt significant portions of the IRC as of a certain date and update their conformity date on a periodic basis. Most of these states enacted legislation during their 2023 legislative sessions to advance their IRC conformity date past Jan. 1, 2022. As a result, some of the uncertainty surrounding the conformity of static states has been alleviated by the 2023 conformity legislation. Most of the static states now conform to the post-2021 R&E expenditure rules, absent legislation specifically decoupling from this federal provision.

A few states, such as Arkansas and Oregon, are selective-conformity states that adopt only certain portions of the IRC, with the state tax code conforming to, or decoupling from, IRC provisions. These states should be separately considered in determining whether they conform to Sec. 174 as amended by the TCJA.

Some states do not conform to Sec. 174 as amended. For example, California and Texas (to the extent the cost-of-goods-sold deduction is applied for Texas franchise tax purposes) generally decouple from the provisions of the TCJA, including the post-2021 expenditure rules, due to their pre-2018 conformity dates. Also, Wisconsin specifically adopts a version of Sec. 174 that existed prior to the enactment of the TCJA.

In Michigan, taxpayers have the option to conform to the current IRC or the IRC as of Jan. 1, 2018, with such provisions actually “in effect” on such date. However, opting to use the IRC as of Jan. 1, 2018, has significantly broader implications than conformity to Sec. 174 that should be considered prior to making such election. As discussed below, several states have enacted legislation that specifically decouples from Sec. 174 as amended by the TCJA.

State legislation decoupling from Sec. 174 as amended

a few states have enacted legislation that expressly decouples from Sec. 174 and allows taxpayers to continue to deduct R&E expenses. In 2022, Tennessee was the first state to enact legislation to decouple from Sec. 174 as amended by the TCJA. During the 2023 legislative season, decoupling legislation also was enacted by Georgia, Indiana, Mississippi, and New Jersey. A consideration of each state’s legislation is warranted because the states follow different approaches for decoupling from Sec. 174.

Georgia: Georgia is a static-conformity state that enacted omnibus tax legislation, Act 236 (S.B. 56), on May 2, 2023, which advanced its IRC conformity date to Jan. 1, 2023, beginning with the 2022 tax year. This same legislation expressly decoupled from Sec. 174 for tax years beginning on or after Jan. 1, 2022. As a result, taxpayers are allowed to immediately deduct R&E expenditures.

Indiana: On May 4, 2023, Indiana enacted omnibus tax legislation, P.L. 194 (S.B. 419), which advanced the state’s IRC conformity date to Jan. 1, 2023, beginning with the 2022 tax year. Also, this legislation decoupled from the federal provisions concerning the treatment of R&E expenditures. For tax years beginning after Dec. 31, 2021, Indiana decouples from Sec. 174 by providing a deduction for “specified research or experimental expenditures” for the tax year and an addition for the amount deducted under the federal provision requiring that R&E expenditures be capitalized. As explained in the legislative summary, this amendment could expedite the deduction and lower the taxable income of businesses that have qualified R&E expenditures during the tax year.

Mississippi: Mississippi generally adopts the IRC as currently amended. On March 27, 2023, the state enacted H.B. 1733, which expressly decouples from Sec. 174 for tax years beginning in 2023 and beyond, allowing Mississippi taxpayers to immediately deduct R&E expenditures that are paid or incurred in connection with their trade or business. This deduction is allowed notwithstanding any potential future federal changes related to the depreciation of R&E expenses. However, taxpayers may instead elect to follow the R&E depreciation provisions under Sec. 174 currently in effect. Note that there is a one-year gap in the effective dates between the federal change and the Mississippi decoupling legislation.

New Jersey: New Jersey is a rolling-conformity state that generally adopts the IRC as currently amended. On July 3, 2023, New Jersey enacted major tax reform legislation, Ch. 96 (A.B. 5323), containing a provision that retroactively decouples from Sec. 174 for corporation business tax (CBT) purposes in certain instances. The legislation expressly decouples from Sec. 174 for privilege periods beginning on and after Jan. 1, 2022, allowing taxpayers in New Jersey to immediately deduct R&E expenditures for which a state R&D credit is claimed, notwithstanding the timing schedule required by Sec. 174 for the deduction of specified R&E expenditures.

The decoupling from Sec. 174 applies only to taxpayers with New Jersey qualified research expenditures (QREs) that actually claimed the New Jersey tax credit. If no New Jersey R&D credits are being claimed, the state follows the Sec. 174 amortization and capitalization rules, and deductions occur in the same period as they would for federal income tax purposes. If the taxpayer is claiming New Jersey R&D credits for New Jersey QREs, the state decouples from Sec. 174 amortization and capitalization rules as they relate to New Jersey QREs. Due to this complexity and partial decoupling from Sec. 174, taxpayers should thoroughly examine the treatment of Sec. 174 for New Jersey CBT purposes.

Tennessee: Tennessee generally adopts the IRC as currently amended. In March 2022, Tennessee became the first state to enact legislation, S.B. 2397, which became effective for the 2022 tax year and beyond, that expressly addressed the Sec. 174 amendments. Under the legislation, for purposes of computing Tennessee “net earnings” or “net loss,” Sec. 174 is applied as it existed immediately before the enactment of the TCJA. The Tennessee Department of Revenue issued guidance in May 2022 clarifying the legislation. For excise tax purposes, pursuant to the version of Sec. 174 in effect prior to the TCJA, a taxpayer who has paid or incurred R&E expenditures may immediately deduct such expenditures in the tax year during which the R&E expenditures are paid or incurred. For tax periods beginning on or after Jan. 1, 2022, taxpayers will need to make adjustments to net earnings or loss subject to excise tax.

State conformity to Sec. 174 is a moving target

The amendments to Sec. 174 enacted by the TCJA have important federal and state tax ramifications, given that the federal changes may materially affect the overall calculation of a taxpayer’s income tax base, especially for taxpayers that heavily invest in R&E activities as a means to spur technological development in their business operations. In some cases, taxpayers that would have been in an overall loss position but for this change may instead find that they have federal income tax liability due. This may cause parallel issues in states that conform to the federal changes to Sec. 174. As for nonconforming states, to be sure, taxpayers may benefit in the year in which a full deduction is allowed but will need to remember that the deductions taken in future years in conforming states will not be allowed in the nonconforming states. State activity in this area will require multistate taxpayers to closely track these differences to properly calculate the tax base in the jurisdictions in which they are subject to tax.

Considering the amount of state legislative activity in this area during 2023, there is also a possibility that other states may decide to enact legislation permanently decoupling from current Sec. 174. Taxpayers should carefully consider conformity to Sec. 174 on a state-by-state basis and continue to monitor legislation, regulations, or state administrative guidance that may affect a state’s conformity to this provision. Furthermore, taxpayers should evaluate the interaction with and the effect of Sec. 174 rules on state R&D credits, as well as the impact on the Sec. 163(j) business interest expense deduction limitations and other limited deductions.

Editor Notes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C. For additional information about these items, contact Fairbanks at greg.fairbanks@us.gt.com. Contributors are members of or associated with Grant Thornton LLP.