Companies that have a history of deducting research and experimental (R&E) expenses will need to prepare for a bigger tax bill. Prior to this, businesses have been able to deduct their R&E expenses in the same year in which they incurred them. However, for tax years beginning after December 31, 2021, all businesses will need to amortize their R&E expenses – 5 years for R&E performed in the US, and 15 years for R&E performed outside the US. The new rule to Section 174 of the tax code is a result of the Tax Cuts and Jobs Act (TCJA) passed in 2017. The change has been a long time coming and will require a significant amount of work for businesses to implement.
Who is Affected?
R&E expenses are costs incurred during the development of new or improved products, processes, techniques, formulas, inventions, or software that are directly connected to the taxpayer’s trade or business. The provision to expense them is intended to encourage research and experimentation, and qualifying expenses may be both direct and indirect. Expenses could include wages paid to employees who are directly involved in R&E activities as well as individuals who supervise and support their work. It could also include contract research expenses, lab supplies, rent, utilities, and attorney fees. Based on the IRS definition, a business can have R&E activities even if they do not necessarily qualify for the research and development (R&D) tax credit.
Why the Change?
While the change came about with the passage of the TCJA, no one expected the provision to be enacted. It was included as a revenue raiser to counter the overall cost of the TCJA with the expectation that a subsequent law would be passed to reverse it. Bipartisan support exists to postpone the change, but the timing of any legislative action is unclear and the outcome is uncertain. Some lawmakers have attempted a legislative fix that could be attached to a funding bill, but there are significant procedural and political obstacles to overcome.
While it’s possible Congress may yet decide to defer this provision of Section 174, financial statements must be prepared based on current law, which means taxpayers need to determine the impact of this change on interim period financial statements and estimated taxes for the first quarter of 2022. Since companies will no longer be able to take the entire deduction for the expense in one year, taxable income for businesses with R&E activities will increase, as will taxable income for business owners. In addition, businesses that previously took advantage of the R&D credit will no longer be able to claim the entire amount, since the R&D credit is limited to the amount expensed that year.
Impact – More Work & Higher Tax Bill
This change will affect many businesses, even those that don’t take the R&D credit. To enact the change, businesses will need to analyze and potentially revise their methodology for determining Section 174 costs, which may require significant work and will likely involve evaluating several data sources. Businesses that have previously benefited from the ability to deduct R&E expenses will likely see an increase in their taxable income.
If you believe you have R&E activities, call Hare CPA today. We are prepared to help you plan for and implement these and other tax code changes going forward.