For many companies, research and development (R&D) is a critical component of their operations and their success. It has also been – until this year – a way to lower their income tax burden. But that may change as a result of a modification in the Internal Review Code (IRC) that was enacted in 2017 but will go into effect this year.
Since 1954, a company’s R&D activities, including pursuing technological innovation, has been deemed a deductible business expensed rather than a taxable capital asset amortized over time. Yet now, as a result of this revised IRC that eliminates the immediate expensing of R&D costs, a company with a significant R&D budget might face a dramatic increase in taxable income on its 2022 returns as well as a larger federal income tax obligation. There are also new requirements for record-keeping, classification, and reporting requirements for R&D expenses.
R&D Expense Deductions: What’s Changing
IRC Section 174 has allowed businesses that incur certain R&D costs—which the tax code refers to as “research and experimental” (R&E) expenditures—to treat these costs as a current business expense and deduct them in the year they are incurred. The objective has been to encourage research into new products, techniques, and equipment that would help the U.S. science, technology, and manufacturing sectors maintain a competitive edge.
R&E expenditures that were eligible for same-year expensing include salaries, supplies, materials, cloud computing costs, and other overhead operating costs related to eligible research activities, as well as the costs of outsourced research projects conducted by contractors or engineering organizations. Expenditures for research equipment, machinery, or buildings were not eligible for same-year expensing.
If a company chose not to take advantage of same-year expensing, it had several options. It could amortize eligible R&E costs over five years, beginning at the time the company first received an economic benefit from the expenditure. Or it could write off these costs over 10 years, beginning at the time the costs were incurred.
Except for special circumstances—such as a pending sale or a company operating at a loss with no current tax obligation—businesses generally would elect to deduct their research costs in the same year they were incurred. But, as of this year, that option is no longer available.
The end of same-year expensing is part of the Tax Cuts and Jobs Act of 2017 (TCJA). To offset the impact that lowered tax rates would have on the federal deficit, the TCJA made various changes to the tax code. Among these was a revision to IRC Section 174 that eliminated the option to deduct R&D costs as a current business expense, beginning with the 2022 tax year.
Unless Congress acts to either repeal or delay the TCJA changes – which is still a possibility – expenditures for research conducted within the U.S. will now need to be capitalized and amortized over a five-year period, beginning at the midpoint of the year in which the expenditure is made. For research conducted outside the U.S., the amortization period is 15 years.
Other R&D Incentives
The IRS has also updated other tax rules that involve R&D expenditures, such as the R&D tax credit under IRC Section 41. Fortunately, the new amortization requirements under Section 174 do not apply to the R&D credit. That credit is still calculated based on all eligible costs incurred during the year.
It’s worth noting, however, that the costs eligible for the R&D tax credit are not identical to the costs to be amortized under Section 174. Taxpayers will need to analyze their R&D budgets to identify those costs that are not eligible for the credit but which still need to be capitalized and amortized.
The recently signed Inflation Reduction Act increased the potential value of the R&D credit. It raises the maximum credit for certain small startup businesses that can apply the credit toward their payroll taxes instead of their income tax liability. This increase, however, does not begin until next year.
A company engaged in R&D activities should begin planning now for this change so it is not caught unaware or ill-prepared when preparing its 2022 tax return. A good first step would be to review the qualification and documentation requirements under IRC Section 174. With this insight and direction, a company can then modify how it tracks R&D costs to make sure these expenses are appropriately classified for reporting.
The tax professionals at Dembo Jones are prepared to help you navigate these changes, new regulations and new reporting requirements. Contact us today.