For government contractors navigating a complex and evolving regulatory environment, the enactment of P.L. 119-21, commonly known as the “One Big Beautiful Bill Act,” marked a significant milestone, providing new opportunities for the industry.
The bill extended key provisions of the Tax Cuts and Jobs Act (TCJA), creating greater certainty in tax planning and liability forecasting for contractors. Additionally, P.L. 119-21 introduced measures that directly affect cash flow, including immediate expensing for research and experimentation (R&E) costs, the restoration and permanent enactment of 100% bonus depreciation, and the return of the earnings before interest, taxes, depreciation and amortization (EBITDA)-based calculation of the limitation for business interest expense.
Section 174A: R&E Expensing
The 2025 tax reform bill enacted new Section 174A, which fundamentally changes the tax treatment of domestic R&E expenditures. Beginning in 2022, businesses were required to capitalize and amortize domestic R&E expenses over five years and foreign R&E expenses over 15 years.
The bill reverses this treatment for domestic R&E by allowing qualifying expenditures to be immediately expensed; the provision is retroactive to expenses incurred as of the beginning of 2025. This change is particularly beneficial for government contractors in R&E-intensive industries such as defense, aerospace and technology — many of whom were subject to addbacks since 2022.
Key features of Section 174A include:
- Immediate Expensing: Qualifying domestic R&E expenditures — including salaries, materials and certain overhead — can be deducted in the year incurred.
- Retroactive Relief for Small Businesses: Small businesses meeting the Section 448(c) gross receipts test may elect to apply immediate expensing retroactively to tax years beginning after December 31, 2021, by filing amended returns within one year of P.L. 119-21’s enactment.
- Transition Relief: All taxpayers may elect to deduct any remaining unamortized domestic R&E from 2022 – 2024 either entirely in 2025 or ratably over 2025 and 2026, treated as a change in accounting method. Alternatively, taxpayers may choose to continue amortizing capitalized costs as currently scheduled.
- Coordination With R&D Credit: For tax years beginning after December 31, 2024, Section 174A deduction must be reduced by the amount of the Section 41 research credit claimed; alternatively, taxpayers may elect a reduced credit under Section 280C(c).
- Foreign R&E: Immediate expensing is not available for foreign R&E, which must continue to be capitalized and amortized over 15 years.
Impact of Section 174A on Government Contractors
- Cash Flow Improvement: Immediate expensing reduces taxable income in the year R&E costs are incurred, improving cash flow.
- Incentive for Innovation: The provision encourages continued investment in R&E, which is critical for contractors seeking to meet government requirements and remain competitive.
- Compliance Requirements: Contractors must ensure that claimed expenses meet the definition of R&E under Section 174A and are properly documented, especially for cost-reimbursement contracts.
- Administrative Complexity: Retroactive application and transition relief may require amending prior returns and careful tracking of R&E expenditures.
Section 168(k): Bonus Depreciation
The 2025 tax reform extends and makes permanent 100% bonus depreciation for qualified property placed in service after January 19, 2025. Qualified property generally includes assets with a recovery period of 20 years or less, including certain computer software, water utility property and qualified improvement property.
Impact of Section 168(k) on Government Contractors
- Capital Investment Incentive: Contractors can immediately expense the full cost of qualifying assets, improving cash flow and encouraging investment in equipment and technology needed for contract performance.
- Contract Costing Considerations: For cost-reimbursement contracts, contractors must ensure that depreciation methods align with Federal Acquisition Regulation (FAR) and Cost Accounting Standards (CAS), as immediate expensing may not always be allowable for government reimbursement.
- Financial Reporting: Accelerated depreciation may reduce reported profits in the short term, affecting financial statements.
Section 163(j): Interest Expense Deduction Limitation
The 2025 tax reform modifies Section 163(j) by restoring the EBITDA-based limitation for business interest expense. This change allows businesses to add back depreciation, amortization and depletion when calculating adjusted taxable income (ATI), increasing the amount of deductible interest for most contractors.
Impact of Section 163(j) on Government Contractors
- Enhanced Deductibility: Contractors with significant debt-financed operations, especially in capital-intensive industries, can deduct a greater portion of interest expense, improving cash flow.
- Complexity: Calculating ATI and tracking carryforwards of disallowed interest remains complex and requires careful tax planning.
Section 199A: Qualified Business Income Deduction
P.L. 119-21 makes the Section 199A, Qualified Business Income (QBI) deduction permanent, increases the phase-in threshold and establishes a minimum deduction for active business income. Section 199A allows a deduction of up to 20% of qualified business income for pass-through entities such as S corporations, partnerships and sole proprietorships.
Impact of Section 199A on Government Contractors
- Tax Savings for Pass-throughs: Many small and mid-sized government contractors benefit from the QBI deduction, which reduces their effective tax rate and frees up resources for growth.
- Limitations: The deduction is subject to wage and capital limitations, and phase-outs apply for high-income taxpayers. Planning can make a significant difference in tax liabilities and proper documentation and compliance are essential.
Strategic and Compliance Considerations for Government Contractors
- Alignment With Government Contracting Rules: Contractors must ensure that tax strategies align with FAR and CAS requirements, particularly for cost-reimbursement contracts.
- Documentation: Robust accounting systems and documentation are necessary to substantiate R&E, depreciation and interest deductions.
- State Tax Conformity: Not all states will conform to the new federal provisions, so contractors must review state law for the treatment of R&E and bonus depreciation.
- Retroactive Opportunities: Small businesses may benefit from retroactive application of Section 174A, but this requires timely amended returns and careful review of prior R&E expenditures.
Enhanced Opportunity Brings Increased Compliance
The 2025 tax reform provisions — Section 174A (R&E expensing), Section 168(k) (bonus depreciation), Section 163(j) (interest expense limitation), and Section 199A (qualified business income deduction) — offer substantial opportunities for government contractors to improve cash flow, incentivize innovation and reduce tax liabilities.
However, these benefits come with increased compliance and administrative complexity, particularly regarding documentation, contract accounting standards and state tax conformity. Contractors should work closely with tax professionals to maximize benefits and ensure compliance with both federal and contract-specific requirements.
Your Guide Forward
To understand how the 2025 tax reform affects your government contracting business and to develop a tailored strategy, contact your Cherry Bekaert professional. Our Government Contractor Consulting team is ready to help you navigate the new tax landscape with clarity and confidence.
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