Restoring tax incentives for innovative businesses

Issue

In 2017, Congress changed longstanding tax treatment for research and development (R&D) expenditures incurred in connection with the development or improvement of a product. Beginning with expenses in tax year 2022, the U.S. tax code requires companies to capitalize R&D costs and amortize them over a five-year period for domestic research and over 15 years for foreign research. Previously, businesses could deduct 100% of R&D expenses from their income in the year they incurred those expenses. 

Qualifying R&D expenses include, for example:

• Wages and salaries of researchers 

• Materials and supplies used in qualified research

• Costs of operating and maintaining research facilities (e.g., rent, utilities, and insurance)

Carta supports immediate restoration of the full R&D expense deduction, which provides a crucial incentive for companies in the private sector to invest in cutting-edge research and development that leads to job creation, technological innovation, and shared prosperity. 

Background

In 1954, in the first decade of the Cold War, Congress enacted Section 174 of the Internal Revenue Code. Section 174 gave companies a choice of two options for recouping R&D expenditures: they could either immediately deduct the expense from their income, or choose to amortize the expense over a period of at least five years. 

This policy incentivized companies to undertake novel research that has led to technological and scientific innovation across sectors and enabled the U.S. to secure and retain its advantage in the global tech economy.

How full R&D expensing benefits startups

The option to immediately deduct R&D expenses—that is, deduct them from business income in the year the expenses were incurred—is a particularly beneficial tax incentive for young companies. While larger, established companies can often confidently project their revenue and expenses over a five-year period, many young companies don’t make it to the five-year mark. 

Startups are disproportionately responsible for innovations, and for a small business trying to innovate in a high-tech sector, immediate and full R&D expense deduction provided a way to offset the capital intensity of high-tech product development, including ​​designing, testing, and improving new products or services. This allowed visionary upstarts to challenge entrenched incumbents, generating cycles of healthy market competition through innovation. 

Changes to R&D expensing

In 2017, Congress ended the successful and longstanding policy of allowing immediate expensing. To offset the cost of other tax incentives enacted by the Tax Cuts and Jobs Act of 2017 (TCJA), Congress altered Internal Revenue Code section 174 to require companies to amortize R&D expenses over a period of five years, or 15 years if the research was conducted outside the United States. The amortization requirement began for all R&D expenses incurred starting in the 2022 tax year. The law also requires software development costs to be treated as R&D and amortized as such.

This change marks a significant departure from the innovation-driving tax policies that enabled the growth and maturation of the U.S. tech economy as we know it. The new policy has already generated financial hardships for tech startups, hindered job creation, and made it harder for American companies to compete in research-intensive industries, including clean energy, health and biotechnologies, and artificial intelligence (AI). If left in place, it could jeopardize American competitiveness in the global economy, as well as national security.

Policy outlook

The 100% R&D expense deduction endured for almost 70 years because it was, and remains, a bipartisan issue. Lawmakers on both sides of the aisle—including progressive Democrats—agree that restoring full R&D expensing under section 174 should be a priority for lawmakers. 

In January 2024, the House of Representatives passed a bill, the Tax Relief for American Families and Workers Act of 2024, that would temporarily restore 100% R&D expensing through the end of 2025, when many important provisions of the TCJA are set to expire and tax policy will become a strong policymaker focus.

The Tax Relief for American Families and Workers Act of 2024 has not received a vote in the Senate, and thus far lawmakers have failed to restore full R&D tax expensing. 

Carta will continue to engage lawmakers to take swift action to restore this vital tax incentive, and  work with our Innovation Coalition partners to shape tax policies that empower small businesses and strengthen economic competitiveness.

Bottom line

Without adequate tax incentives to support R&D in the private sector, the U.S. risks falling behind foreign competition in developing the technologies that will power tomorrow’s economy. 

Many other countries—including by foreign adversaries—provide their industries with much greater support on research and development. There is much more the United States can do to support the innovation economy, incentivize scientific and technological research, and foment job creation through R&D. 

Get involved

To learn more about how to get involved in Carta’s work to create public policy for tomorrow’s innovation economy, including full restoration of R&D expensing, write us here.

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