The Tax Cuts and Jobs Act (“TCJA”), signed into law on December 22, 2017, brought about significant changes to the U.S. tax landscape. This article provides an educational overview of the TCJA's implications on research and experimentation (R&E) considerations, particularly those changes that took effect for tax years beginning after December 31, 2021.
TCJA introduced changes to the treatment of specified research or experimental expenditures under Section 174 (“§174”), requiring capitalization of these expenditures for the 2022 tax year and thereafter. Conforming amendments to Sections 41 (§41) and 280C (§280C) under the TCJA may offer taxpayers enhanced tax savings opportunities. Taxpayers must be aware of the implications when filing a return with the R&D Tax credit claimed using Form 6765.
Prior Treatment of R&D Credits under Section 280C
Before the passage of the TCJA, §280C(c)(1) disallowed a deduction for the portion of the Qualified Research Expenses (QREs) equal to the amount of the research credit claimed. This was to prevent taxpayers from getting both a deduction and a credit for the same amount. To avoid adjusting federal taxable income by this disallowed tax deduction, taxpayers could elect under §280C(c)(3) to reduce the current year research credit amount by the maximum corporate tax rate of 21%.
Changes Brought by the TCJA
The TCJA mandates that specified R&E expenditures under §174, for tax years starting post-2021, must be capitalized and amortized over a five-year period for research conducted within the U.S. and 15 years for research outside the U.S. The revised §174 specifically requires software development costs be capitalized and amortized over a five or fifteen year period, stating “...any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure” but this provision was recently further qualified and clarified by IRS guidance issued on September 14, 20231. If there's a retirement, abandonment, or disposal of property related to these expenditures, for example and if the research fails to result in any usable work product or intellectual property, the remaining basis must still continue to be amortized over the remaining period.
Conforming Amendments to Sections 41 and 280C
TCJA introduced amendments to §41 and §280C, effective for the 2022 tax year and thereafter. The changes redefine "qualified research" and how credits are determined and applied.
Section 41: This section incentivizes taxpayers to invest in domestic R&D through the provision of tax credits calculated as a portion of their domestic R&D expenses. Pre-TCJA, taxpayers had the option to either expense or capitalize QREs under §174. Post-TCJA, QREs must be capitalized and amortized (for the first time since 1954).
Section 280C: TCJA removed previous references in §280C(b)(2) about capitalizing rather than deducting expenses, given the new capitalization and amortization requirements under §174.TCJA also deleted certain language from §280C(c) that disallowed a tax deduction for QREs in the amount of the research credit for a given taxable year. However, it retained the portion relevant to capitalizing and amortizing R&E expenditures. This could render the §280C(c) election irrelevant for tax years beginning on or after January 1, 2022.
Implications for Taxpayers
The changes introduced by TCJA, especially the capitalization requirement under §174 and the amendments to §41 and §280C, will likely provide taxpayers a mechanism for additional tax savings: being able to claim their R&D credit with no impact on taxable income. When electing the gross credit, if the 2022 R&D credit exceeds the allowable QRE deduction, your CPA would have to reduce the amount chargeable to the capital account by the excess amount.
However, the IRS has not yet to issue comprehensive guidance on these changes, leading to uncertainty. Taxpayers should be cautious and consider this uncertainty when making decisions on the applicability of §280C to current research credit claims. Given the complexities introduced by the TCJA and the potential tax savings opportunities, it's crucial for taxpayers to consult with financial advisors or tax professionals to fully understand the implications. Proper guidance can ensure that they maximize benefits while remaining compliant with the updated tax code.
Taxpayers must consider the TCJA's effective date when making estimated tax payments and updating financial statements. Many individuals and businesses familiar with claiming the §41 R&D credit may not fully realize the extent of deductible expenses under §174's wider definition. This includes not only direct costs but also indirect expenses such as depreciation, amortization, or depletion of assets utilized in §174 research and experimentation (R&E) activities. For instance, the depreciation of a research facility or office, alongside facility-related overheads like rent, utilities, insurance, taxes, repairs, and maintenance, security, and travel expenses, can all be considered. It's important to reassess these expenses in light of the recent IRS Section 174 guidance to ensure maximum benefit. With all this complexity, it’s important to have a trusted firm that can articulate these nuances to your accountant.
Reach out to Strike to ensure your R&D calculations are accurately calculated and you receive the proper recommendations regarding Sections 41, 174, and 280C of the IRC.
1 Guidance on Amortization of Specified Research or Experimental Expenditures under §174 Notice 2023-63, issued by the IRS on 9/14/23 qualified R&E expenses under §174 as those that met the uncertainty test as well as the test for risk and retained rights, https://www.irs.gov/pub/irs-drop/n-23-63.pdf