The federal research and development (R&D) tax credit has been providing a compelling savings to companies engaged in qualified activities for many years. One of the most attractive aspects is the ability to deduct expenses in the year incurred. This not only provides an immediate benefit but offers access to the funds necessary to offset ongoing expenses. Unfortunately, companies engaged in research and development activities will no longer be able to take an immediate deduction but will now be required to capitalize and amortize eligible expenses. The provision allowing the immediate deduction has expired numerous times in past years. In each of those cases, Congress moved to restore the deductibility of R&D expenses prior to the due dates for tax returns. However, they have not yet moved to restore deductibility for 2022 or beyond. To help clients, prospects, and others, WhippleWood CPAs provided a summary of the key details below.
How has Section 174 made changes to research and expenditures beginning in 2022?
Instead of costs for research and development projects being deducted in the year conducted, the new rule under IRC Section 174 means companies will have to amortize eligible expenses over a 5-year period for domestic research and 15-years for foreign activities. This means businesses will have to wait substantially longer to receive the tax benefit. In addition, there will also be an impact on the organization’s tax position since an immediate deduction is no longer available.
Should we elect not to calculate the R&D Credit to take the deductions?
The rules for the capitalization of the deductions operate independently of the rules for taking the R&D Credit. Even if you avoid claiming the R&D Credit, you are still required to capitalize the R&D Expenses.
What is included under research costs?
The scope of what is covered under research is still unclear, with more guidance needed to better outline what might apply under Section 174. However, it is clear that the costs that must be capitalized instead of expensed are different than the costs used in the calculation of the R&D tax credit. The costs that must be capitalized are generally broader than those eligible for the tax credit.
Research and experimental expenditures has been defined in general as applying to all “costs incident to the development or improvement of a product.” Products that have been included under this definition could be “any pilot model, process, formula, invention, technique, patent, or similar property.” There are some exclusions listed, including quality control testing, consumer surveys, advertising, efficiency studies, and literary or historical research.
Section 174 also explicitly names software development costs as activities that fall under research & development. This definition lacks the certainty many tax professionals are accustomed to receiving. There is a great dela of uncertainty about which software development costs are eligible due to the lack of recent IRS guidance. In fact, the guidance has not been updated since 2000 and doesn’t account for the many updates over that time.
Because of these changes, a catch-all definition that used to be helpful can now be detrimental, prompting the push toward greater clarity. As it stands, the rule could be argued to include rent, utilities, non-research personnel costs, and more. In response, the IRS has acknowledged the uncertainty and may do more to identify what costs should be included, adopt a more comprehensive approach, or provide a safe harbor for filers.
What is the American Innovation and Jobs Act?
The American Innovation and Jobs Act was introduced to the Senate on March 16, 2023. One of the proposed measures in the Act concerns repealing the new amortization rules. If passed, it will also expand the R&D tax credit to startups and more small businesses. The legislation was recently referred to the Committee on Finance, so it is unlikely that any major changes will be made in the immediate future.
What does this mean for my 2022 return?
The expectation is that Congress will eventually retroactively restore the deduction for R&D expenses. However, returns that are filed prior to Congress making that change must capitalize those expenses. If a business files its return before Congress changes the law, it will need to file an amended return to claim the deductions in 2022. Congress may provide alternatives that allow the deduction in 2023 instead. We generally advise clients with research and development to wait to file returns until closer to the extended deadline. That way, if Congress updates the law, the deductions can be claimed without an amended return. If a business files its returns prior to the change, the business should evaluate the options that Congress provides for the most advantageous method of claiming the deductions under their individual circumstances.
With much remaining uncertainty, it can be difficult to know how to categorize or declare R&D activities. While legislative efforts are currently underway to reverse the change, it is important for those claiming the R&D credit to plan ahead. If you have questions about the information outlined above or need assistance claiming the R&D tax credit, WhippleWood CPAs can help. For additional information call 303-989-7600 or click here to contact us. We look forward to speaking with you soon.