Startups Discover Avenues for "Bigger Deductions" Under Evolving IRS Section 174 R&D Rules

Startups are finding new opportunities to optimize their tax positions and potentially reclaim funds, despite recent changes to the Internal Revenue Service's (IRS) Section 174. David J Phillips, an expert in R&D tax credits, highlighted this development, stating, "This is a rare win for startups. Clean rules, bigger deductions, and real money back if you acted under the old law." This sentiment points to a growing clarity in navigating the complex tax landscape for research and development expenditures.

The shift in Section 174, enacted as part of the 2017 Tax Cuts and Jobs Act (TCJA), mandated that businesses capitalize and amortize research and experimental (R&E) expenditures over five years for domestic activities and fifteen years for foreign activities, effective for tax years beginning after December 31, 2021. Previously, companies could immediately deduct these costs, a practice that encouraged innovation. This change significantly impacted cash flow and increased taxable income, particularly for R&D-intensive startups, including pre-revenue entities and those funded by grants.

In response to the adverse effects on innovation, bipartisan efforts have been underway in Congress to repeal or delay the Section 174 capitalization requirement. Bills such as the "Tax Relief for American Families and Workers Act" passed the House but stalled in the Senate, while the "American Innovation and R&D Competitiveness Act of 2025" continues to seek a return to immediate expensing. These legislative attempts underscore the widespread recognition of the challenges posed by the current rules.

Amidst legislative uncertainty, the IRS has issued interim guidance, including Notices 2023-63 and 2024-12, which provide crucial clarifications on the treatment of specified research and experimental expenditures. These "clean rules," as referenced by Phillips, help businesses better understand which costs fall under Section 174 and how to properly classify them, especially regarding contract research. Such guidance enables companies to navigate compliance more effectively and identify eligible deductions.

For startups, optimizing their tax strategy under these evolving rules involves careful expense categorization and leveraging the R&D tax credit (Section 41). While Section 174 mandates capitalization, the R&D tax credit still offers a dollar-for-dollar reduction for qualified research expenses, provided the activities meet specific criteria and are not federally funded. Expert guidance can help businesses identify eligible expenses, distinguish between Section 174 and Section 41 requirements, and potentially amend past returns to claim previously overlooked benefits.

Phillips, known for his work with R&D tax credits, emphasized the potential for "bigger deductions, and real money back," suggesting that proactive engagement with these clarified rules, combined with strategic tax planning, can yield significant financial advantages for startups. The ongoing dialogue between policymakers and the IRS, alongside the efforts of tax experts, continues to shape a more navigable path for innovative companies.