Taxpayers with research expenses may be negatively impacted by a delayed change stemming from the 2017 Tax Cuts and Jobs Act (TCJA). Understanding the implications of this change is essential for those with such expenses in tax years beginning after December 31, 2021.
Background
Previously, “research expenditures,” as defined under section 174 of the Internal Revenue Code, could be expensed as a reduction to taxable income by their full amount in the current year. This option to immediately deduct qualified research expenses has been available since 1954, but the TCJA changed the rules. While making the research and experimentation (R&E) tax credit permanent, the TCJA also requires capitalization of research expenses for tax years beginning after December 31, 2021. These capitalized expenses are then amortized over five years for activities conducted in the U.S. and its possessions, or over fifteen years for foreign activities.
Tax Impact
Many have inquired how mandatory research expense capitalization will impact research efforts, and in turn those who take the related tax credit. In the long-term, taxpayers will continue to see benefits from utilizing the R&E tax credit.
However, newly required capitalization of research expenditures can cause a sizable jump in 2022 federal taxable income, when compared to prior years. This change creates a timing difference which will allow a taxpayer to realize only 10 percent of the initial expenditures as an amortization expense, due to the half-year convention in the first and last years, and 20 percent for years in between.
Example: X Co. has $1 million in domestic research expenses in 2022. In years prior, X Co. could have fully expensed $1 million in the current year, but it now must capitalize those costs and amortize them over 5 years resulting in a $100,000 current year tax deduction in 2022 ($1 million/5 years x 50 percent half-year convention).
This temporary decrease in cash flow may be too great for small businesses to bear, potentially pushing them out of engaging in research that can have far reaching benefits for their companies.
Additionally, for taxpayers taking the research credit, the rules under section 41 as to what costs qualify for the credit are more restrictive than the broader rules of section 174. This means that more costs may be required to be capitalized than those reported on federal Form 6765. For example, all software development will be considered research and must be capitalized for tax purposes regardless of whether the taxpayer claims the research tax credit. It’s also important to note that not all states conform to the TCJA’s treatment of research expenses and therefore it’s possible to have a situation where expenditures are capitalized for federal purposes, but expensed at the state level.
Finally, changing from expensing to capitalizing research expenditures will require a change in accounting method. The IRS recently released favorable guidance detailing that the change will be automatic, on a cut-off basis, and that for 2022 a statement can be attached to the income tax return in lieu of filing Form 3115.
Outlook
Many believed mandatory research expense capitalization would either be repealed or postponed before the end of 2022, however despite bipartisan congressional and broad industry support to do so, efforts have failed. Thus, until Congress acts, the change remains in effect. It is still possible that a retroactive change will be made, potentially in the coming months, as lawmakers remain focused on restoring immediate research expensing.
In the meantime, please consult your RubinBrown tax advisor with questions or concerns.
Published: 1/17/2023
Readers should not act upon information presented without individual professional consultation.
Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.