The federal rules for deducting research and development costs are settling after changes under the One Big Beautiful Bill Act. However, as many states move to decouple from these new provisions, taxpayers are facing significant uncertainty and compliance challenges.
States create ‘hodgepodge’ of R&E rules
Following the federal retroactive reinstatement of immediate expensing for domestic research and experimental (R&E) costs under new IRC § 174A via the OBBB, the focus has shifted to the states. And many states are not automatically following the federal government’s lead.
The result is a “hodgepodge of different approaches that the states have taken,” said former Congressman Rick Lazio, who is now a senior vice president at alliant. While some states like California and Illinois automatically conformed to the federal changes, Lazio told Checkpoint, others have opted out or created their own unique rules. This is creating a complex compliance map for businesses operating in multiple jurisdictions.
Lazio said this complexity disproportionately affects small and medium-sized businesses, which often lack the internal tax and legal teams to navigate the conflicting rules. “You’ve got smaller businesses that don’t have a team of accountants, lawyers, finance people in-house,” he explained. “When they start hearing that they’ve got different treatment at the state and federal level, many of them decide they’re just not going to take advantage of the federal credit, even though they’re eligible for it.”
The fear of getting it wrong, coupled with the potential for audits, can be a powerful disincentive. Dean Zerbe, managing director at alliant and former senior counsel to the Senate Finance Committee, noted that small businesses “really get grinded by the expensing issue.”
Zerbe described how the previous federal requirement to amortize R&E costs, which the OBBB reversed, could turn a healthy small business’ finances upside down. A company that was “$400,000 in the black suddenly is $1 million in the red for a tax bill,” Zerbe explained. And this includes businesses such as “40-person tool and die shops” and “30-person engineering shops.” For these businesses, the confusion and complexity at the state level represent another potential trauma they are keen to avoid, Zerbe added.
A patchwork of state approaches emerges
State approaches to § 174 and § 174A conformity are highly varied. States often are trying to strike a balance between budget concerns and encouraging innovation. The result for some is new rules that favor smaller businesses.
Add-back provisions: New York decoupled from § 174 and § 174A, and the full amount of any federal deduction for R&E expenditures must be added back on New York State tax returns. However, New York allowed businesses with under $31 million in gross receipts to deduct expenses for tax years 2022 – 2024 assuming they also properly deducted those expenses on the federal side, Lazio and Zerbe said.
Meanwhile, Maine passed legislation that requires taxpayers to add back a varying percentage of their domestic R&E deduction. And while small businesses can deduct R&E expenses retroactively, the deduction is phased out for larger companies, Lazio and Zerbe explained.
North Carolina, likewise, decoupled from federal law and is requiring taxpayers that took a deduction for domestic R&E expenditures to add back 80% of the amount taken for the year. Taxpayers can deduct 25% of the add-back portion over a four-year period.
Small business carve-outs:Vermont decoupled from the federal change but created a carve-out allowing businesses with under $31 million in gross receipts to deduct the expenses going forward.
And Minnesota and Pennsylvania are requiring amortization only for C corporations, effectively shielding the majority of small businesses that operate as pass-throughs, Lazio and Zerbe said.
Budget pressures, politics drive state decisions
According to Lazio, state budget issues are a primary driver for decoupling. However, he cautioned that the savings are an “illusion,” because the required amortization under the old rules simply back-loads the tax deductions. “You may think that you’re getting savings for this year … but you’re going to be having to cover that tab in three years,” he said.
Lazio said that analysis from Minnesota, which never adopted the 2022 federal R&E expensing change, suggests the fiscal impact of providing immediate expensing for small businesses is minimal. There, he explained, the state Department of Revenue found that only 3.6% of state credits were claimed by companies with under $50 million in sales. This data indicates that a state can conform for smaller businesses without taking a major hit to its budget, Lazio said.
Ultimately, by not conforming, a state risks “sending a signal that we don’t much care what type of business you are or how you invest in yourself,” Lazio warned. This could encourage innovative companies to relocate to more tax-friendly states, costing the non-conforming states future growth, investment, and tax revenue, he added.
“State legislatures could follow other states’ models, creating a legislative carve-out for small businesses, either by gross receipts or by entity type,” said Lazio and Zerbe.
“In the meantime, businesses need to treat their research expenditures correctly regardless of whether or not they claim credits,” they added. “The sooner a business comes into compliance, the sooner their amortization from prior years will level things out.”
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