What expense category is Research and Development (R&D) Costs?

For innovative businesses, investing in research and development (R&D) is the engine of future growth. These costs, which range from researcher salaries and lab supplies to software development, are critical for creating new products or improving existing ones.

However, recent changes to the tax code have fundamentally altered how businesses must treat these expenses. R&D costs are no longer a simple, currently deductible expense. The IRS now has mandatory rules that require these costs to be capitalized and recovered over time. This guide will explain the correct tax treatment for R&D costs to ensure your business remains compliant.

Research and Development (R&D) Costs Category

The costs you incur for research and development are capital expenditures.

Under a significant change in tax law for tax years beginning after 2021, IRS Publication 535 states that specified research or experimental expenditures must be capitalized and amortized (deducted in equal amounts) over a set period. You can no longer elect to deduct these costs in the year they are incurred.

Important Considerations While Classifying R&D Costs

To correctly handle these expenses, you must understand what the IRS considers an R&D cost and what is excluded.

What Qualifies as a Research and Experimental Expenditure?

According to Publication 535, R&D costs are expenses for activities intended to eliminate uncertainty about the development or improvement of a product. This includes:

• Costs incurred in an experimental or laboratory sense.
• The costs of developing software.
• The costs of obtaining a patent, including attorney's fees for the application process.

What Costs are NOT R&D?

Publication 535 provides a specific list of costs that do not qualify as R&D expenditures. These include:

• Advertising or promotional expenses.
• Consumer surveys or management studies.
• The cost of acquiring land or depreciable property to be used in the research.
• Exploration costs for minerals, oil, or gas.
• The cost of acquiring another's patent, model, or process.

Mandatory Amortization

The rule requiring capitalization and amortization of R&D costs is now mandatory. The previous option to deduct these expenses currently has been eliminated for tax years beginning after 2021.

Tax Implications and Reporting

The tax treatment for R&D costs requires capitalization and amortization over a specific period.

The Amortization Period

According to Publication 535, you must amortize R&D costs over the following periods, beginning at the midpoint of the tax year in which the costs were paid or incurred:

• 5-year period for research conducted in the United States.
• 15-year period for any foreign research.

How to Report the Deduction

The annual amortization deduction for your R&D costs is calculated and reported on Form 4562. The total from this form is then carried to your main business tax return.

The R&D Tax Credit

Separately from the amortization deduction, your business may be eligible for the Credit for Increasing Research Activities. This is a tax credit calculated on Form 6765 that can offset your tax liability.

What Records to Keep

You must maintain meticulous records to substantiate all R&D costs. This includes:

• Invoices for lab supplies and materials.
• Payroll records for researchers and developers.
• Contracts for any third-party research services.
• Documentation detailing the nature and purpose of the research projects.

How Fyle Can Automate Tracking for R&D Costs

Fyle helps you capture and organize all the costs associated with your R&D projects, providing a clean record for your accountant to handle the mandatory amortization.

• Track by R&D Project: Code all expenses—from lab supplies to contractor payments—to a specific research project.
• Centralize All Invoices: Have your suppliers and research partners email invoices directly to be forwarded to Fyle for automatic data capture.
• Create a Clear Audit Trail: Fyle maintains a complete, unalterable record of all project costs, which is crucial for substantiating your capitalized basis.
• Automate Your Accounting: Sync capitalized R&D costs to the correct asset account in QuickBooks, Xero, NetSuite, or Sage Intacct.