Exploring the Impact of Section 174 on R&E Expenditures
In the past, a taxpayer could elect to expense and immediately deduct R&E expenditures, but since Congress has not revised a law change from five years ago, there may now be an immediate significant impact to taxable income for affected returns.
The Tax Cuts & Jobs Act (TCJA) amendment to § 174 requires R&E expenditures to be capitalized and amortized over a period of five years if in the U.S. or 15 years if foreign, for amounts paid in tax years starting after Dec. 31, 2021. Additionally, software development costs are specifically included as R&E expenditures under § 174(c)(3) and, therefore, will be subject to the same mandatory amortization period of five or 15 years.
Prior to 2022, taxpayers had the option to either deduct their R&E costs or to capitalize and amortize such costs over a period of not less than 60 months. Under the new law, that option has been eliminated.
Additionally, taxpayers were able to make an election under § 59(e) to amortize R&E expenditures over 10 years. Similar options existed for the treatment of software development costs under Rev. Proc. 2000-50, which provided taxpayers the option to currently expense costs as incurred, amortize over 36 months from the date the software was placed in service, or amortize over not less than 60 months from the date the development was completed.
The statute specifies that amortization will begin with the midpoint of the taxable year in which expenses are paid or incurred, creating a significant year one impact. For example, assume a calendar-year taxpayer incurs $5 million of R&E expenditures in 2022. Before the TCJA, the taxpayer would have immediately expensed all $5 million on its 2022 tax return, assuming it did not make an election under § 174(b) or § 59(e) to capitalize the amounts. Under the new rule, the taxpayer will be entitled to amortization expense of $500,000 in 2022, calculated by dividing $5 million by five years, and then applying the midpoint convention in the first year of amortization to haircut the annual amortization amount in half.
Impact to IRC §41 & §280C
The TCJA also amended IRC Section 41(d)(1) to define qualified research as research “with respect to which expenditures may be treated as specified research or experimental expenditures under Section 174.”
The TJCA amendment of § 280C includes removal of the former requirement of a corresponding reduction to the §174 deduction by an amount equal to the research credit claimed in such tax year.
When taxpayers do not elect the reduced § 41 R&D credit under § 280C, the excess of the research credit over the current-year R&E amortization deduction reduces the current year amount of R&E capitalized. For example, in 2022, the research credit percentage will need to exceed 10% for a taxpayer to experience any addback. Electing the reduced credit will no longer be advantageous for many taxpayers.
While the most obvious impact of § 174 is a temporary increase to taxable income (or temporary decrease to taxable loss) that will ultimately reverse in future years, there are other tax provisions for which the treatment of R&E expenditures and/or the determination of taxable income are relevant that could also be affected by the change. In certain instances, the difference could result in a permanent difference to a taxpayer’s lifetime taxable income, resulting in a difference to its effective tax rate. With the new capitalization requirement in place, some areas taxpayers should pay attention to as they begin to consider tax provision and taxable income projection implications for 2022 include:
- 250 Foreign Derived Intangible Income (FDII) deduction: FDII benefits may increase due to increased taxable income (and therefore deduction-eligible income and foreign-derived deduction-eligible income) as a result of capitalized R&E expenditures.
- 163(j): Increased taxable income resulting from the capitalization of R&E expenditures may reduce disallowed business interest expense under § 163(j) in a given year.
- 250 Global Intangible Low-Taxed Income (GILTI) calculation: The requirement to capitalize and amortize foreign R&E expenses over 15 years may have a significant impact on the amount of tested income.
- 861 allocations: Provisions involving the allocation of R&E expenditures, including FDII, GILTI and the foreign tax credit, should ensure that all costs identified as § 174 amounts are allocated in accordance with the rules provided under Treas. Reg. §1.861-17.
- Evaluation of whether to utilize R&D credit against payroll tax credit
- 199A Qualified Business Income considerations
- State and local tax effects for adjustments in non-conforming jurisdictions
- Accounting method change statement will need to be attached to 2022 return.
Although the law may still be repealed or delayed, it is important to evaluate how the transition to capitalizing § 174 expenses will impact your 2022 and future year income tax liability. Determining this impact may depend, in part, on a taxpayer’s method of accounting. However, the change may significantly increase current taxable income if the law is not modified.
As it stands now, affected taxpayers will need to develop a plan to identify and track § 174 expenses to ensure accurate tax filings. If you have questions about R&E expenditure capitalization under IRC § 174 and how the new rules could impact your business, contact an Adams Brown advisor.