Passed in 2017, the sweeping tax reform known as the Tax Cuts and Jobs Act (TCJA) was passed as part of the budget reconciliation process, which required that the reform not add to the deficit beyond ten years. Many of the reforms were considered to be “taxpayer favorable” and included the popular Section 199A Qualified Business Income Deduction and a reduction in the corporate tax rate. However, in order to pass these reforms, the bill also required items that would be “pay-fors” and offset the cost of these cuts. Among these included the State and Local Tax (SALT) Cap and a provision starting in 2022 that changed the impact of Research and Development (R&D) Costs for all taxpayers.
Prior to the TCJA, since the passage of the Internal Revenue Code of 1954, taxpayers have been able to deduct R&D Costs under Section 174 as they we incurred, similar to any other trade or business expense. Starting in 2022, taxpayers lose the option to deduct R&D costs in the year they are incurred and under the new rule, taxpayers must capitalize and amortize R&D Costs over a five-year period for research conducted in the US, or over a 15-year period for research conducted overseas. The impact of this will be most felt in the first years this is effective, as there are no prior capitalized costs that would be a deductible amortization expense in this year; by the time year 5 of this provision is effective, conceptually speaking the impact to a taxpayer who regularly spends on R&D would be somewhat negligible. For many early-stage companies, the impact may also be “bottom line” unimportant as these companies often have expenses far in excess of their income or have prior losses which can offset any increase in taxable income as a result of capitalization; but for profitable firms with extensive R&D expenditures this has the potential to be a significant tax burden.
Broadly, R&D costs for tax purposes refers to the process of designing, creating, and testing new products, processes, or technologies in a laboratory or experimentation sense. Under the Regulations of Section 174, the IRS has defined R&D costs more by what are not considered R&D than what are, but includes all costs incidental to the development of a product or process. The TCJA has explicitly included software development costs as expenses under this provision, which prior were either capitalized or deducted based on the taxpayer’s election.
Taxpayers are likely most familiar with R&D expenses when thinking about the Section 41 Credit for Increasing Research Activities (R&D Credit). The two sections are very closely linked (as the credit is based on R&D expenses), however there are certain costs previously deductible as R&D expenses such as indirect labor & the full amount of contract expenditures and may also include costs that don’t rise to the level of experimentation or uncertainty otherwise required to claim the credit. From a practicality perspective, the same analysis and costs can be used as a starting point for many taxpayers, but it is important to note that there could be additional costs that may be impacted by this. Further, to be clear – this change does not impact the ability to otherwise claim the R&D credit for taxpayers; however, it does impact the Section 280C addback of expenses.
In December 2022 the IRS released Revenue Procedure 2023-8 which provides an automatic change procedure for impacted taxpayers; in plain English, this means that taxpayers that need to start capitalizing these costs do not need to go through the length and complicated procedures to obtain a change of accounting method but rather have been granted this change automatically. Typically, a change in accounting method (even if required by law) can require a taxpayer to file additional forms with the IRS which can increase the cost, complexity, and possibility for error with their returns. In order to comply with this revenue procedure, taxpayers will need to include a statement with their return that includes:
A. Name & EIN of the taxpayer
B. Beginning and Ending dates of the taxable year the change takes effect
C. The designated accounting method change number (265)
D. A description of the type of expenditures
E. The amount of R&D expenditures in the year of change
F. A declaration that the taxpayer is changing the accounting method
This change is one that has been on the horizon for a number of years for taxpayers, but the story is not yet over. From nearly the moment this was enacted, the expectation from both taxpayers and congressional leaders has been that this would ultimately be repealed or at least delayed. There have been numerous proposals in congress to repeal or delay this, however to date none of them have come to pass. Currently, there is still support to repeal this but a split congress and additional goals (many want to tie a repeal or delay to continuing the expanded child tax credit) leaves us with a lot of uncertainty. While we still believe the general expectation that this is repealed or delayed will happen prior to many taxpayers filing 2022 returns, we can no longer, for lack of a better term, ignore this potential item.
For most taxpayers, the distinction between R&D Expenses and ordinary trade or business expenses was not particularly impactful (as both were deductible), except for claiming the R&D Tax Credit. Starting in 2022, all taxpayers will need to be aware of this change and make a determination if they are required to capitalize expenditures and amortize over 5 years rather than deduct immediately as incurred. This change impacts the taxable income of taxpayers but will not impact the R&D tax credit otherwise; nor will it impact taxpayers ability to claim the credit. Impacted taxpayers should start working with advisors to identify costs and prepare to make the required statement, as required, with their 2022 return, unless congress is able to meet the expectations of many and repeal or delay this change.
Edward McWilliams, CPA
Partner
Ed is a Partner in the firm’s tax and business advisory practice focusing on providing services to middle market private companies across different industries as well as to early stage startups. Ed has over a decade of experience providing tax and business consulting services to these companies of different sizes and across different industries, bringing a broad and diverse knowledge base and strategic solutions to the many complex issues that businesses face.
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