The Problem with 174

You didn't think tax was easy, did you?

The One Big Beautiful Bill Act introduced a long-awaited and much-celebrated fix for 174, allowing for the immediate deduction of research expenses once again. And, even better than initially anticipated, the bill provided for a retroactive application for small businesses. None of that has changed, but there remains an issue with the bill's language that hopefully the IRS will address ahead of this fall’s filing season. That issue concerns yet-to-be-filed 2024 returns for small businesses, and the election for immediate deduction must be implemented through an amended return.

Photo by Karla Hernandez on Unsplash.

The Issue with 2024

The change to 174 generally applies to tax years beginning after December 31, 2024, i.e., tax year 2025. The bill provides additional relief for small businesses through an election available for the 2022-2024 tax years. While the manner in which the taxpayer must make the election is left up to the Treasury, the bill requires that “the taxpayer shall file an amended return for each taxable year affected by such election.” This makes perfect sense for most tax years, and likely most taxpayers, who have filed 2022, 2023, and even 2024 by this point. But for those taxpayers who extended 2024 and are planning to file in the next few months, do they have to file an original return, amortize their 174 expenses on that return, pay the outstanding tax, and then file an amended return to invoke the election and deduct the same expenses and receive a refund? (Yes, the taxpayer could not pay and let the amended return settle the balance, but given the difference in processing times of timely filed and amended returns, this comes with other risks.)

But does the bill require an amended return?

The election provision starts with the language that “at the election of an eligible taxpayer, paragraphs (1) and (3) of subsection (e) shall each be applied by substituting ‘December 31, 2021’ for ‘December 31, 2024.’” Applying that to the first paragraph of subsection (e) provides the following: “Except as otherwise provided in this subsection or subsection (f)(1), the amendments made by this section shall apply to amounts paid or incurred in taxable years beginning after December 31, 20242021.”

So, the election ensures the change is active before filing the return. But, it is hard to separate the first sentence of the election from the third sentence of the same (three-sentence) paragraph. The question becomes, what does “affected by such election” mean in this context? An amended return is required if “affected” means any instance where the taxpayer wants to apply the election to the tax year. However, if “affected” means that the election changes the original return, there is a case to be made that no amendment is needed if the expenses were deducted on the original return.

Does this make sense for the tax system?

Amending a tax return, even when anticipated, is not an abstract cost. There is time associated with creating the amended return, reversing the amortization schedule, and filing the return, which is usually a cost to the taxpayer. And there are potential pitfalls with the amended process, including lost returns, improper return processing, and slower review processes. These have lessened with the expansion of electronic filing, but have not been fully resolved. And for flow-through entities, the number of amended returns skyrockets. From a taxpayer's perspective, it makes sense to be able to file the correct return the first time.

It seems unlikely that the IRS would support requiring an amended return. The National Taxpayer Advocate’s report to Congress stated that the IRS has lost ~26% of its workforce this year, and the turnover in leadership has been widely reported on, and is still working through the backlog of amended returns filed for ERC. To artificially require taxpayers to file an amended return for an election that should be available when filing seems like an undue burden on the IRS.

What happens next?

Ideally, the IRS will issue guidance on this in the very near term. Even though the bill was only passed two weeks ago, the fall filing season is already underway. Some taxpayers may benefit from waiting and relying on guidance that is hopefully (but certainly not guaranteed to be) forthcoming, but others may not have that option. For those, it becomes a risk tolerance question for the taxpayer and their tax professional. The safe process is also the most costly, requiring an amended return, but is unlikely to be challenged by the IRS or rejected by the courts. The more straightforward process of claiming the deduction on the original return is the most logical process for taxpayers and the IRS. Still, it comes with a risk if the IRS does not issue guidance and decides to reject the election.

Wrap-up

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The content of this article is for informational purposes only and should not be taken as tax, legal, benefits, financial, or HR advice. I am a lawyer, but receiving this newsletter does not mean I am your lawyer. Since rules and regulations change over time and can vary by location, consult a lawyer or HR expert for specific guidance.