Contrary to expectations, Congress closed out 2022 without restoring taxpayers’ ability to fully deduct research and development (R&D) expenditures in the year incurred. Consequently, as businesses look to file their 2022 tax returns, they may be surprised to find higher taxable income and a larger tax bill than they had expected. They may also find it challenging to categorize and calculate the R&D expenditures they now must capitalize, even if they already claim the lucrative R&D tax credit.
Historically, Section 174 of the U.S. tax code had allowed taxpayers to immediately deduct all their qualifying R&D expenditures in the year incurred. However, the Tax Cuts and Jobs Act of 2017 (TCJA) amended this taxpayer-friendly provision for years starting after December 31, 2021, by requiring businesses to capitalize and amortize R&D expenditures over five years or 15 years for R&D activities conducted outside the U.S. This new rule applies even when taxpayers close, retire or abandon a project under development.
The IRS broadly defines these costs as those “incident to the development or improvement of a product” and “paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business.” While this new treatment of R&D costs ultimately may yield the same tax impact at the end of the amortization period, businesses today will find themselves in a position that threatens their ability to maintain liquidity, fund future R&D spending, hire new employees and pay their tax bills.
One of the ways businesses can offset higher tax bills and improve cash flow surrounding these R&D costs is to claim the federal R&D tax credit. Under Section 41 of the tax code, eligible taxpayers may receive a dollar-for-dollar tax credit for their qualified research expenses (QREs), including activities related to the development, design or improvement of products, processes, formulas, techniques or software.
Conducting an R&D tax credit study is also an excellent way for businesses to understand the R&D costs that exist within their organizations. However, it is important to note that taxpayers may still need more clarification when they find a mismatch between their calculation of expenses they must capitalize under Section 174 and those that may qualify for immediate tax savings via an R&D tax credit.
Generally, expenses qualifying for the R&D tax credit under Section 41 are less inclusive than those defined for capitalization under Section 174. For example, the R&D tax credit allows the inclusion of U.S.-based W-2 wages, direct supplies and 65 percent of qualified costs paid to third parties. By contrast, costs taxpayers must amortize under Section 174 are much more broadly defined and may include those related to R&D, including U.S. and foreign gross wages, employee benefits, overhead, occupancy costs, patent-related legal costs and 100 percent of costs paid to qualified contractors. Additionally, the TCJA expanded the definition of Section 174 expenditures to include “any amount paid or incurred in connection with the development of any software.”
For example, consider a U.S. company that incurred $1 million of domestic-development costs in 2021 (before the rule change). The company could immediately deduct that $1 million in 2021. However, that same $1 million the company spent in 2022 must be capitalized and amortized over five years using a half-year convention resulting in a mere $100,000 deduction in 2022. In both scenarios, the company could also take advantage of the federal R&D tax credit, but its 2022 taxable income would still be higher due to its inability to deduct $900,000 of those costs.
While we wait and see if Congress acts to reverse the Section 174 amortization rules this year, the IRS issued guidance under Revenue Procedure 2023-08 (superseded by 2023-11) to help taxpayers more easily change their accounting method for complying with the capitalization and amortization requirements for tax year 2022. Rather than requiring businesses to file a Form 3115, Application for Change in Accounting Method, qualifying taxpayers may instead file a statement with their 2022 tax returns for the change take effect automatically.
The advisors and accountants with PKF Advisory have deep experience helping businesses across a broad range of industries navigate and calculate federal and state tax credits and deductions, including those related to research and development activities.
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