1. Introduction: The New R&D Landscape
The tax treatment of research and experimental (R&E) expenditures for U.S. businesses has undergone significant changes with the enactment of the One Big Beautiful Bill Act (OBBBA) in 2025. For S corporations, which pass through deductions and credits to shareholders, understanding these changes is crucial for maximizing tax benefits and ensuring compliance. This blog analyzes the following example scenario:
Calendar-year S corporation has $2.4 million in domestic software development and $600,000 in foreign testing for 2025. Under §174A, Camer Corp can expense the $2.4 million or elect to amortize it over at least 60 months?
2. Domestic R&E: Expensing or Amortization under §174A
A. Immediate Expensing
For tax years beginning after December 31, 2024, new §174A allows a full deduction for domestic R&E expenditures—including software development—in the year incurred. This means the S corporation can deduct the entire $2.4 million in 2025, reducing taxable income and increasing cash flow for shareholders.
B. Optional Amortization
Alternatively, the corporation may elect to capitalize and amortize domestic R&E over a period of at least 60 months, starting with the month the benefits are first realized. This election must be made by the return due date (including extensions) and, once made, must be consistently applied to subsequent years unless IRS consent is obtained for a change.
Key Points:
- Expensing provides an immediate deduction, which may be preferable for companies seeking to minimize current-year taxable income.
- Amortization may be advantageous for smoothing deductions over several years, especially if the company anticipates higher income in future years or wants to align deductions with revenue recognition.
C. Software Development as R&E
Software development costs are explicitly included as qualifying R&E expenditures for both expensing and amortization under §174A .
3. Foreign R&E: Mandatory 15-Year Amortization under §174
Foreign R&E expenditures—including foreign software testing—must be capitalized and amortized ratably over 15 years, starting at the midpoint of the year incurred. No immediate deduction is allowed, and the amortization continues even if the related property is disposed of, retired, or abandoned.
For 2025:
- The $600,000 in foreign testing must be amortized over 15 years, with the first deduction beginning at the midpoint of 2025.
- If the foreign project is abandoned or sold, the amortization schedule continues; no loss or basis adjustment is allowed.
4. Transition Relief for 2022–2024 Domestic R&E
If the corporation capitalized domestic R&E in 2022–2024 (as required under prior law), it has two options for any remaining unamortized balance as of January 1, 2025:
- Option 1: Deduct the entire remaining balance in 2025.
- Option 2: Amortize the remaining balance ratably over 2025 and 2026.
This election is treated as a change in accounting method, implemented on a cut-off basis with no §481(a) adjustment required. After this transition, the corporation aligns its 2025 and future-year treatment with §174A (i.e., immediate expensing or new amortization election).
5. Research Credit and §280C(c)(2) Election
A. Research Credit Eligibility
The research credit under §41 is available for qualified research expenses (QREs), which generally include domestic R&E expenditures. Foreign R&E may not qualify unless it meets the requirements for U.S.-based research under §41(d)(4)(F).
B. Deduction Reduction under §280C(c)(1)
If the research credit is claimed, the deduction for related R&E expenses must be reduced by the amount of the credit, unless the taxpayer elects the reduced credit under §280C(c)(2).
C. Late §280C(c)(2) Election
The OBBBA and Rev. Proc. 2025-28 allow a late §280C(c)(2) election for prior years (2022–2024) by filing amended returns within one year of enactment (by July 4, 2026). This election allows the corporation to:
- Claim the full deduction for R&E expenditures.
- Take a reduced research credit (reduced by the maximum corporate tax rate, 21% for C corporations; for S corporations, the reduction is at the shareholder level).
The corporation may also revoke a prior §280C(c)(2) election for any applicable year by amended return, but this must be done via amended returns, not by accounting method change.
6. Tax Implications and Reporting
A. U.S. (Domestic) R&E
- Expensing: Immediate deduction reduces taxable income for 2025, increasing cash flow and potentially increasing the QRE base for the research credit.
- Amortization Election: If amortization is elected, only the annual amortization amount is deductible each year, which may be preferable for smoothing taxable income or aligning deductions with revenue recognition.
- Transition Relief: Deducting or amortizing the remaining 2022–2024 balance in 2025 or over two years can create a significant deduction in 2025 (or 2025–2026), but may interact with other loss limitation rules (e.g., §461(l), §465, §469).
B. Foreign R&E
- Amortization Only: No immediate deduction; the 15-year amortization delays tax benefits and may create a book-tax difference.
- No Acceleration: Even if the foreign project is abandoned or sold, the amortization schedule continues; no loss or basis adjustment is allowed [2].
C. Research Credit
- Domestic QREs: The $2.4 million in domestic software development is likely eligible for the research credit, subject to the requirements of §41 and related regulations.
- Foreign QREs: The $600,000 in foreign testing may not qualify for the credit unless it meets the requirements for U.S.-based research under §41(d)(4)(F).
- Deduction Reduction: If the research credit is claimed, the corporation must reduce its deduction for R&E by the amount of the credit unless the reduced credit election is made under §280C(c)(2) .
7. Case Law and Advance Rulings
- Snow v. Commissioner, 416 U.S. 500 (1974): The Supreme Court held that R&E expenditures “in connection with” a trade or business are broadly construed, supporting the inclusion of a wide range of costs as deductible or amortizable under §174 .
- IRS Rulings: The IRS has consistently required strict adherence to the statutory and regulatory framework for R&E deductions and credits. Recent guidance (e.g., Rev. Proc. 2025-28) emphasizes procedural compliance for elections and method changes.
8. 2026 IRS Updates and Guidance
A. Rev. Proc. 2025-28
- Procedural Guidance: Provides detailed procedures for making elections, changing accounting methods, and filing amended returns for both transition relief and ongoing compliance with §174A.
- Automatic Method Changes: Most changes to the treatment of domestic R&E are automatic and implemented on a cut-off basis (no §481(a) adjustment), except for certain retroactive small business elections.
- Form 3115: Generally not required for changes to §174A methods; a statement in lieu of Form 3115 is sufficient for most elections.
B. Notice 2023-63
- Interim Guidance: Provides definitions and allocation rules for SRE expenditures, including software development, and clarifies the treatment of costs, contract research, and the impact of asset dispositions.
- Consistency Requirement: SRE expenditures must be treated consistently for all tax purposes; they cannot be deducted under other sections (e.g., §162, §263A) if subject to §174 or §174A.
9. Practical Considerations for S Corporations
- Pass-Through Treatment: As an S corporation, deductions and credits pass through to shareholders. The research credit is claimed at the shareholder level, and the §280C(c)(2) election affects the amount of deduction and credit passed through.
- State Tax Implications: Some states do not conform to federal R&E expensing or credit rules; state-level analysis is necessary.
Conclusion
For 2025 and 2026, S corporations benefit from the permanent restoration of immediate expensing for domestic R&E under §174A, while foreign R&E remains subject to 15-year amortization. Transition relief allows for accelerated recovery of previously capitalized domestic R&E. The ability to make or revoke late §280C(c)(2) elections provides flexibility in maximizing the combined value of deductions and credits. However, strict procedural compliance is essential, especially for S corporations passing benefits to shareholders. Taxpayers should carefully model the impact of these choices, considering both federal and state tax implications, and monitor ongoing IRS guidance for further clarifications—especially regarding software development and contract research arrangements.
