Businesses with R&D Expenditures Must Prepare for the Risk of Higher Taxes by Karen A. Lake, CPA
Posted on March 27, 2023
by
Karen Lake
Congress closed out another year without restoring taxpayers’ ability to fully deduct research and development (R&D) expenditures in the year incurred, a taxpayer-friendly provision of the Internal Revenue Code that had been in place for nearly 70 years before 2022. This change has had significant implications for many businesses that were again surprised to find they had higher taxable income last year and a larger tax bill than expected.
Background
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.
Potential Workaround
One way 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 their organizations’ R&D costs. However, taxpayers may still need more clarification when they find a mismatch between the 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. They 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 and 2023 must be capitalized and amortized over five years using a half-year convention, resulting in a mere $100,000 deduction in both years. In both scenarios, the company could also take advantage of the federal R&D tax credit, but its 2022 and 2023 taxable income would still be higher due to its inability to deduct $900,000 of those costs.
While we wait to see if Congress acts to reverse the Section 174 amortization rules, the IRS has issued a series of guidance and revenue procedures to help taxpayers more easily change their accounting method to comply with the capitalization and amortization requirements. The advisors and accountants with Berkowitz Pollack Brant 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.
About the Author: Karen A. Lake, CPA, is a state and local tax (SALT) specialist and an associate director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where she helps individuals and businesses navigate complex federal, state and local tax laws, and credits and incentives. She can be reached at the firm’s Ft. Lauderdale office at (954) 712-7000 or info@bpbcpa.com.
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