Understanding section 174 R&D costs: A guide for life sciences companies

Section 174 of the Internal Revenue Code governs how companies handle research and development costs for tax purposes. The recent passage of the One Big Beautiful Bill Act (OBBBA) brings significant changes, affecting how life sciences companies, including those developing new drugs, therapies and medical devices, account for these vital expenses.

This article provides an overview of section 174 and the newly enacted 174A, explains the options for expensing or amortizing research and development (R&D) costs, highlights some key issues in mergers and acquisitions, and identifies important state and local tax considerations. We also provide actionable planning opportunities to help life sciences organizations.

Why section 174 matters

Innovation is the lifeblood of the life sciences industry. Companies invest heavily in R&D to develop breakthrough treatments and innovative medical technologies. Over the past 10 years, both large biopharma and medtech companies have more than doubled their R&D spend, despite geopolitical conflict, challenges with U.S. and global regulatory agencies, and evolving health care needs.

Managing the tax treatment of these costs is critical for maximizing cash flow, supporting continued innovation and ensuring compliance. Understanding recent changes to section 174 is essential for finance, accounting and operations teams.

Section 174 explained

Section 174 provides the rules for how companies must treat their R&D expenditures, sometimes with optionality, for U.S. federal income tax purposes. For tax years beginning after Jan. 1, 2022, and prior to OBBBA, businesses could not fully expense their R&D costs in the year in which they were paid or incurred. Instead, such expenditures were required to be capitalized and amortized over a period of five years for domestic costs, and 15 years for foreign costs, using a half-year convention.

What changed?

With the passage of OBBBA, section 174 was amended and section 174A was introduced.

For tax years beginning after Dec. 31, 2024, required capitalization is now limited to expenditures attributable to foreign research. Foreign research is defined, by reference to section 41(d)(4)(F), as research conducted outside the United States, Puerto Rico or U.S. possessions. Section 174 still requires that these foreign R&D expenditures must be amortized ratably over the 15-year period. The 15-year period begins with the midpoint of the tax year when the expenditures were incurred or paid (See IRC 174).

Domestic R&D expenditures (i.e., any expenditures that are not foreign) are now governed by section 174A. Under this new provision, companies have two options for how to treat domestic R&D expenditures incurred in tax years beginning after Dec. 31, 2024:

Alternatively, a taxpayer who adopts a 174A(a) expense methodology may capitalize domestic research expenditures and amortize them over a 10-year period under section 59(e), which is an annual election available to taxpayers versus an accounting method.

Eligible smaller companies may retroactively apply the new rules to tax years 2022 to 2024 if they choose to amend their tax returns. For companies looking to this option, be aware of the interplay with research tax credits and the section 280(C) election, as well as administrative burden, especially for qualified small business taxpayers, including partnerships which would have to file an administrative adjustment request. The determination of whether a taxpayer is a qualified small business taxpayer can be complex and requires analysis of both controlled group and tax shelter rules.

While not retroactive for larger businesses, OBBBA provides an election to accelerate and deduct in the current year any remaining unamortized domestic research expenditures that were incurred in tax years 2022 to 2024. Companies have three options regarding their unamortized domestic costs from 2022 to 2024:

Even if a taxpayer changes to a section 174A(c) capitalization methodology, an accounting method change is required to conform with the new rules. Taxpayers should also consider that section 174A(c) requires project-level tracking of R&D expenditures, which is not a current requirement under the rules in place from 2022 to 2024 (and would similarly not be required under a section 59(e) election.)

Modeling plays a critical role in choosing the appropriate accounting method, and determining the application of any annual elections. Continuing to capitalize and amortize these costs under either section 174A(c) or section 59(e) can help manage tax attributes, including net operating losses, interest deduction limitations and credit interactions.

Choosing to adopt an expense methodology does not necessarily avail taxpayers of the requirement or need to determine their annual section 174 costs. For partnerships, the section 59(e) election is reported at the partner level and is not an entity-level election. For this reason, all partnerships should technically report their section 174 expenditures as a footnote on Schedule K-1. Furthermore, many states do not conform to federal OBBBA treatment and may continue to require the capitalization and amortization of R&D costs, similar to the rules in place for federal purposes from 2022 to 2024 (see below for further discussion).

The bottom line is that the changes under OBBBA can affect the company’s taxable income, cash flow and financial statements. It is important to review whether the business’s R&D costs qualify for immediate deduction and whether it is more favorable to amortize those R&D costs, considering the interplay with section 163(j) and net operating loss limitations. In the life sciences space, evaluating commercialization timelines and potential or planned licensing deals can be of utmost importance in tax planning. For a more detailed discussion, see The OBBBA restores favorable tax treatment of domestic R&D expenses.

Section 174 in mergers and acquisitions

M&A activity is common in life sciences, as companies seek to combine resources, expand pipelines or acquire new technologies. Section 174 costs can present unique challenges in these transactions, including:

• Due diligence and valuation matters: Buyers need to understand how the target company has accounted for R&D costs. Are there significant unamortized section 174 expenses on the books? This can affect purchase price negotiations and future tax liabilities. If identified as part of diligence, remedies may be available via the rules for tax accounting method changes.
• Sale considerations:
  • The seller cannot deduct foreign R&D costs against the sale price of any property attributable to those costs. The treatment is the same whether that property is retired or abandoned.
  • If the seller chooses to accelerate costs, the resulting net operating losses may be limited after the company is sold (i.e., an ownership change under section 382).
• Post-transaction integration: After an acquisition, combining two companies with different section 174 practices (some may expense and others may amortize these costs) can complicate financial reporting and tax compliance. Harmonizing these policies is essential.

State and local tax considerations

Section 174 rules are federal, but state and local tax laws may differ. Some states automatically follow federal rules, while others have their own definitions and treatment for R&D costs. Additionally, several states have adopted legislative changes to section 174 since the enactment of OBBBA. Key issues include:

• Conformity: Does your state adopt the new federal section 174 rules, or does it provide for more generous or restrictive expensing of R&D costs?
• Documentation: States may require separate tracking and substantiation of domestic R&D costs for state tax purposes, even if this is no longer required for federal purposes, thereby increasing administrative complexity.

It is critical to review the rules in each state where your company operates and coordinate with your finance and tax teams to ensure compliance. In addition, consider the following planning opportunities:

• Review and update your company’s R&D cost tracking processes to ensure accurate categorization for both federal and state tax purposes.
• Evaluate the impact of section 174 changes on cash flow and consider timing of R&D expenditures for optimal tax results.
• In M&A deals, conduct thorough due diligence on section 174 positions and plan for integration of R&D accounting policies.
• Consult with your tax advisors to take advantage of any state-specific incentives or relief programs related to R&D.

By staying informed and proactive, life sciences companies can turn section 174 challenges into opportunities for smarter tax planning and continued innovation.