The ability to deduct research and development (R&D) costs as a current business expense, rather than treat them as a capital asset that must be amortized over time, has helped many businesses over the years. By enabling companies to lower their income tax burden, this tax treatment encouraged valuable research and technological innovation.
But a 2017 change to the Internal Revenue Code (IRC), which goes into effect this year, has eliminated immediate expensing of R&D costs. As a result, a company with a significant R&D budget could find itself with an unexpected increase in taxable income on its 2022 return—along with a significantly larger federal income tax obligation. In addition, companies that engage in R&D must also comply with new record-keeping, classification, and reporting requirements.
R&D Expense Deductions: What’s Changing
Since 1954, IRC Section 174 has allowed businesses that incur certain R&D costs—which the tax code refers to as “research and experimental” (R&E) expenditures—to treat these costs as a current business expense and deduct them in the year they are incurred. The objective was to encourage research into new products, techniques, and equipment that would help the U.S. science, technology, and manufacturing sectors maintain a competitive edge.
R&E expenditures that were eligible for same-year expensing include salaries, supplies, materials, cloud computing costs, and other overhead operating costs related to eligible research activities, as well as the costs of outsourced research projects conducted by contractors or engineering organizations. Expenditures for research equipment, machinery, or buildings were not eligible.
If companies chose not to take advantage of same-year expensing, they had several alternatives. They could amortize eligible R&E costs over five years, beginning at the time the company first received an economic benefit from the expenditure. Or they could write off these costs over 10 years, beginning at the time the costs were incurred.
Except for special circumstances—such as a pending sale or a company operating at a loss with no current tax obligation—businesses generally would elect to deduct their research costs in the same year they were incurred. But, as of this year, that option is no longer available.
The end of same-year expensing came about as part of the Tax Cuts and Jobs Act of 2017 (TCJA). To offset the impact that lowered tax rates would have on the federal deficit, the TCJA made various changes to the tax code. Among these was a revision to IRC Section 174 that eliminated the option to deduct R&D costs as a current business expense, beginning with the 2022 tax year.
Unless Congress acts to either repeal or delay the TCJA changes, expenditures for research conducted within the U.S. will now need to be capitalized and amortized over a five-year period, beginning at the midpoint of the year in which the expenditure is made. For research conducted outside the U.S., the amortization period is 15 years.
Other R&D Incentives
The IRS has also updated other tax rules that involve R&D expenditures, such as the R&D tax credit under IRC Section 41. Fortunately, the new amortization requirements under Section 174 do not apply to the R&D credit. That credit is still calculated based on all eligible costs incurred during the year.
Note, however, that the costs eligible for the R&D tax credit are not identical to the costs to be amortized under Section 174. Taxpayers will need to analyze their R&D budgets to identify those costs that are not eligible for the credit but which still need to be capitalized and amortized.
The recently signed Inflation Reduction Act increased the potential value of the R&D credit, raising the maximum credit for certain small startup businesses that can apply the credit toward their payroll taxes instead of their income tax liability. This increase does not begin until next year, however. For now, companies planning to use the R&D credit should review the qualification and documentation requirements to avoid a last-minute scramble to comply.
Preparing for the New Amortization Rules
There is still a possibility that Congress will restore same-year expensing under Section 174 as part of a year-end tax extenders bill. But in the meantime, companies with sizable R&D budgets should get prepared to start capitalizing and amortizing their R&D expenditures for the first time since the 1950s.
Preparation includes ensuring they are accurately tracking R&D costs, including software development costs, and are correctly categorizing them according to the Section 174 classifications. Companies that conduct offshore research might also look into relocating some projects to take advantage of the shorter amortization period for domestic R&D spending.
For more information, please reach out to Holbrook & Manter. We would be happy to assist you.