- TCJA is now in effect for the first tax filing deadline—Section 174 was modified to eliminate the taxpayer’s ability to opt to deduct Research & Experimentation (R&E) expenses such as those related to software and product development.
- Loss of the deduction of current year R&E expenses will create a substantial tax burden for many companies engaged in product development, even if they previously had no taxable income.
- Calculating Section 174 expenses and Section 41 expenses should be done simultaneously. All expenses need to be classified as either-or, in order to make quarterly estimated tax payments and as reflected in timely filed tax returns.
- The R&D tax credit (Section 41) is still available to companies and the best way to reduce the effect of these new rules.
- Strike is available to work with your accounting team / CPA to ensure that you are compliant with Section 174 while maximizing the benefits from Section 41 (R&D tax credits) available to you.
R&D Tax Changes for 2022 and Their Impact
Signed into law on December 22, 2017, the Tax Cuts and Jobs Act (TCJA) eliminated a key provision in Section 174 of the Internal Revenue Code, or §174, that allowed taxpayers to either currently deduct or to capitalize and amortize research and experimentation (R&E) costs over five years. Starting with the 2022 Tax Year (or tax periods beginning after December 31, 2021), taxpayers no longer have the option to deduct all §174 R&E expenses in the current year. Instead, taxpayers must now capitalize and amortize U.S.-based §174 deductions equally over five years and foreign §174 deductions over fifteen years.
Since taxpayers can no longer write-off 100% of these expenses, limiting the amount of deductions businesses can take will create a significant tax burden for many companies.
Those that previously deducted their R&D expenses, had substantial offshore R&D expenses, or that amortized their offshore R&D expenses over five years will particularly be affected.
Because taxable income will increase at the federal level from this change, taxpayers will also potentially have increased state income taxes that result from the increased income recognition.
It is also noteworthy that the TCJA modified the definition of “research or experimental expenditures” in Section 174(a) to “specified research or experimental expenditures”. Section 174(b) defines this term as “research or experimental expenditures which are paid or incurred by the taxpayer during such a taxable year in connection with the taxpayer's trade or business.” The deduction for research expenses under IRC Section 162 as “ordinary and necessary” business expenses was also eliminated by the TCJA.
Software Companies Heavily Affected by TCJA
Companies developing any software are specifically impacted by this definition change. Previously, taxpayers could rely on Rev. Proc. 2000-50 to deduct software development costs in accordance with Section 174(a). Because of this new definition, the TCJA effectively eliminates taxpayers' ability to rely on Rev. Proc. 2000-50 to deduct software development expenditures.
Section 174 vs. Section 41: Classification
It is particularly important to note the difference between §174 “research or experimental expenses” and §41 “qualified research expenses.” Section 174 includes all direct and indirect research costs incurred throughout the year, including all expenditures shown in the table above. However, §41 is limited to only qualified research expenses (QREs) and has more stringent qualification requirements comparted to §174, particularly employee overhead and benefits expenditures.
To put this into perspective, imagine a company with $10M in annual revenues (assume that they consistently spend $3,000,000 on §41 R&D and typically bonus out to minimize their tax bill) has ~$3.4M in §174 R&E expenses. This §174 expense had been fully deductible for the 2021 tax year filing; however, given the mid-year convention for 2022, only 10% ($340,000) of the deduction is allowed, resulting in an additional $3.26M of additional taxable income.
For 2023, another 20%, or $680,000, is deductible each year going forward, and the pattern continues until the deductions for the 2022 investment are completed in 2027 with the last 10%. The increased tax due in this scenario would be over $1,500,000! Fortunately, this taxpayer will still be eligible for roughly $300,000 of R&D tax credits, which will partially offset the increased tax burden.
IRC Section 280C, which prevents a double benefit by disallowing deductions for the expenses determined under Section 41, was also amended under the TCJA. Historically, taxpayers could make an election under Section 280C(c)(2) to reduce the credit by 21 percent, eliminating the need to add-back the amount of R&D credits to taxable income. For tax year 2022, if the amount of the R&D credit exceeds the amount allowable as a deduction, the amount chargeable to a capital account must be reduced by the amount of the excess. Going forward, it could be more favorable to claim the gross credit amount.
Partner with an Experienced R&D Tax Firm
Notwithstanding the increased administrative burden, companies performing R&D should be working closely with their accounting team and CPA to ensure that these changes are reflected in their financial statements. Taxpayers should identify all eligible §174 costs and distinguish these expenses from other categories in real-time. Additionally, CPAs must ensure that only the deductible portion of §174 expenditures are reflected in quarterly estimated tax payments, provision computations, and income tax returns.
The IRS recently released guidance (Rev. Proc. 2023-11), which describes new procedures the IRS will use to change a taxpayer’s method of accounting to comply with the new capitalization and amortization rules. Taxpayers making the change can do so by filing a statement with their federal tax return in lieu of filing the Form 3115, Application for Change in Accounting Method.
There is still a chance in 2023 that Congress takes action to delay the implementation of the amortization requirement, or eliminate the changes altogether. The Build Back Better Act would have delayed this change until 2026; although that bill passed in The House of Representatives, it stalled in the Senate. Given the current political climate, we are in a ‘fingers crossed’ mentality and hope that negotiations resume on this bipartisan topic soon. Interestingly, we have not seen any legislative actions at the state level to specifically address the §174 changes.
As Strike prepares to conduct R&D tax credit studies for 2022, it is important to note that the R&D credit is still the best way to offset the increased tax liability anticipated for many companies. We’ve updated our reports to provide additional schedules that will aid your tax preparer during filing and your Strike team is available to provide consultation throughout your tax planning process. We remain dedicated to discovering and documenting qualifying research activities, and expenses, for all of our clients.