Planning for Capitalization of Research and Experimentation (R&E) Costs
As has been widely reported, for tax years ending after December 31, 2021, the Tax Cuts and Jobs Act (“TCJA”) of 2017 changed the treatment of section 174 of the US Internal Revenue Code (“IRC Section 174”) costs related to research and experimentation (“R&E”) costs. IRC Section 174 R&E costs are defined as expenditures used in connection with a taxpayer’s trade or business which represent research costs in the experimental or laboratory sense. Instead of treating such costs as immediately deductible (as IRC Section 174 allowed in the past), under current law, domestic R&E costs must be capitalized and amortized over five years. Additionally, Foreign R&E costs must be capitalized and amortized over 15 years.
While there is bipartisan support for legislation postponing or eliminating this change, the timing for potential enactment of such a revision to the law is uncertain. Business taxpayers are hopeful that negotiations within Congress related to the United States Competition and Innovation Act (which is currently in conference between the House and the Senate) may restore the current deductibility of IRC Section 174 R&E costs.
In the interim, taxpayers are putting into place processes to better track IRC Section 174 R&E costs to comply with current law. Prior to 2022, taxpayers may not have characterized all applicable R&E costs as IRC Section 174 costs. Instead, they may have just treated such costs as ordinary and necessary costs deductible under IRC Section 162. Under either Sections 174 or 162, costs were currently deductible. Now, because of required capitalization under Section 174, it is imperative to distinguish R&E costs from other ordinary and necessary business expenses.
While contemplating a process to track IRC Section 174 expenses, many taxpayers are focusing first on qualified research expenses (“QREs”) captured under IRC Section 41 for the R&D Tax Credit. QREs, are just the starting point, as they only include taxable box 1 W-2 wages, certain supply costs and 65% of contract research. Additional R&E costs to track include:
- Gross wages for labor instead of Box 1 W-2 wages
- The 35% of contract research costs not treated as QREs
- Facility costs
- Costs subject to depreciation
- Costs of obtaining a patent
- Off-shore R&D
Potential Impacts of Section 174 Capitalization
From a practical perspective, with no current deduction for R&E costs, the required capitalization, and amortization create a timing difference that can impact cash flow and the ability to fund innovation, research, and development activities. Furthermore, the capitalization and amortization of R&E costs will affect the speed at which net operating losses may be generated by start-up companies. The current law also requires that amortization begins with the midpoint of the taxable year in which the IRC Section 174 expenses are paid or incurred.
Below are six additional potential impacts of the requirement to capitalize and amortize R&E costs:
- Abandoned Projects: A taxpayer must continue to capitalize and amortize R&E costs over the five or 15-year period.
- Potentially unavailable tax planning methods:
- Proc. 2000-50 for Software Development Costs
- IRC Section 59(e) election to amortize R&E costs over ten years
- International Tax Impact: R&E costs amortization may affect GILTI, FDII and Foreign Tax Credits.
- State and Local Impact: R&E costs amortization will likely increase federal taxable income, which may increase state and local tax.
- Interest Deduction Limitations: R&E amortization may impact the computation of the interest deduction limitation under IRC Section 163(j).
- Interplay with IRC Section 280C: Under IRC Section 280C deductions are disallowed for otherwise deductible R&E expenses equal to the amount of the IRC Section 41 R&D Tax Credit. Taxpayers often make an election for a reduced credit under IRC Section 280C(c)(3) on a timely filed tax return to reduce the R&D credit by 21% (the maximum corporate tax rate) to avoid this disallowance. The capitalization and amortization requirements of the current law, however, may prevent taxpayers from calculating R&D credits that exceed the allowable deductions – thus, making the election for the reduced credit under IRC Section 280C(c)(3) less favorable from a net benefit perspective.
While most taxpayers and practitioners believe that legislation may restore the ability to currently deduct R&E expenses paid or incurred after December 31, 2021, it is prudent to implement a plan to identify R&E costs and consider the effects of capitalization and amortization according to current law.
If you have questions or want to learn more about the R&D tax credit for your company, consult your Cherry Bekaert advisor or contact Cherry Bekaert’s Tax Credits & Incentives Advisory practice today.