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Research and development activity – the creation of new products, services or ideas – has paid enormous social, economic and political dividends in the United States. Given its value, the federal and state governments have employed a raft of tools, including tax policy, to promote domestic R&D.

Until recently, Internal Revenue Code Section 174, and by extension, the New Jersey Corporation Business Tax Act, provided a number of options, including an immediate deduction for R&D expenses paid or incurred in connection with a taxpayer’s trade or business. Without such an option, R&D expenses may have been subject to capitalization. However, effective beginning 2022, the federal government amended IRC Section 174 to require the amortization of the cost of domestic and foreign R&D expenses over a period of five and 15 years, respectively.

New Jersey, a national R&D hub, faced substantial negative economic effects from this policy change. To mitigate these effects, in July 2023 the New Jersey Legislature passed, and Gov. Phil Murphy signed, legislation that provided for an immediate deduction of New Jersey R&D expenses that were also used to calculate the New Jersey R&D credit.

The intent of the legislation was apparent – to encourage additional R&D activity in the state. The problem with the legislation, however, is that it only applies to business entities subject to the CBT – for example, entities treated as corporations for federal income tax purposes. Partnerships, limited liability companies and other business entities not subject to the CBT, but subject to the New Jersey Gross Income Tax Act, were not mentioned in the legislation; nor have they been historically eligible for the New Jersey R&D credit. In addition, this legislation may unconstitutionally discriminate against interstate and foreign commerce, as it provides preferential tax treatment for economic activity occurring within the state.  However, this issue is outside of the scope of this article.

Unlike the CBT, which generally conforms to the IRC with certain modifications, the GIT is a tax on gross income specifically formulated by statute, which only selectively conforms to the IRC. The GIT requires taxpayers to determine business income by deducting all costs and expenses incurred, determined either on a cash or accrual basis in accordance with federal tax accounting methods. The Division of Taxation, in Technical Bulletin TB-114, has interpreted this provision to apply the five- and 15-year R&D expense amortization provisions of IRC Section 174 to the GIT.

The major problem with the disparate treatment of R&D expenses among CBT and GIT payers is that, according to the IRS’ public records, GIT payers engaged in R&D activity tend to be much smaller enterprises than business entities organized as corporations, with corporate and pass-through filers averaging approximately $5.9 million and $3 million in gross receipts, respectively. For New Jersey to both deprive these smaller enterprises of access to the R&D credit, and now an immediate deduction of R&D expenses, clearly frustrates New Jersey’s policy of encouraging startup R&D ventures. Even worse, many other states provide an across-the-board decoupling from IRC Section 174, making such states more attractive for R&D activity.

Since the New Jersey Legislature very likely did not intend to give large enterprises a tax advantage, and since it very clearly intended to encourage in-state R&D activity, there are a few possible fixes.

The Legislature could pass a technical correction to the July 2023 law to explicitly include immediate deductions of New Jersey R&D expenses under the GIT Act. While this would not put GIT payers at parity with CBT payers (given that CBT payers also receive the benefit of the New Jersey R&D credit), it would help to close the gap.

An administrative fix that bypasses the cumbersome legislative process may also be available. The GIT conformity to federal accounting methods is a rather grey area of the law, which has been often litigated. The Division of Taxation may determine that, since the GIT Act does not specifically make reference to R&D expenses, it may find the amortization requirement under IRC Section 174 inapplicable to the computation of gross income and permit an immediate deduction. The Division of Taxation has taken similar action in the recent past by interpreting a 2019 CBT reform surtax provision as not applying to S corporation income, as stated in Technical Bulletin TB-84(R).

The current interpretation of the application of IRC Section 174 to GIT payers puts smaller research firms at a distinct disadvantage vis-à-vis large corporations that are offered both the benefit of the New Jersey R&D credit and immediate deduction of New Jersey R&D expenses. A policy disadvantaging the research activities of smaller enterprises appears to be the exact opposite of New Jersey’s goal of attracting high technology startups to the state. Either the New Jersey Legislature or the governor’s office should use the powers at their disposal to provide a remedy.

Michael Puzyk is a tax partner in the Newark office of McCarter & English LLP. He advises leading domestic and international businesses, organizations and individuals in all aspects of state and local taxation, with an emphasis on New Jersey tax matters.