R&D Amortization: It’s Not Gone Yet, What Do We Do?
Co-Authored by: Kelly Morningstar, CPA, MBA
By now, most of you have heard much discussion regarding the requirement to capitalize and amortize research and development (R&D) expenses. So many things have been written and speculated that you may be more confused now than you were before! In the following few paragraphs, we will unpack how we got here, what it means, what could still happen, and most importantly, what we do now!
The requirement to capitalize and amortize research and development expenses originates with the Tax Cuts and Jobs Act (TCJA), signed into law by President Trump in December 2017. While this legislation generally provided a series of tax cuts for businesses and individuals, the cuts had to be paid for.
One of the provisions in TCJA to control its overall cost was the little-publicized provision to modify Internal Revenue Code §174 with a delayed effective date of tax years beginning after December 31, 2021 (2022 calendar year). Before 2022, companies had the option of immediately expensing Section 174 costs or amortizing them over time. Most companies would choose to take an immediate tax deduction. Beginning in 2022, an immediate deduction is no longer an option. Section 174 expenses incurred in the United States must now be capitalized and amortized over five years, and foreign expenses over 15 years.
While this is merely a timing difference (you will still get to write off the entire cost over time), many companies have been shocked to learn what this really means to their 2022 tax bills.
Take a small company with $2 million of annual R&D expenses (not unusual for, say, a relatively small architectural or engineering firm). In the past, the entire $2 million would be written off in the year incurred. That makes sense for an AE firm as these costs are generally wages and related costs incurred in the delivery of their services, i.e., their cost of goods sold.
In 2022, the entire $2 million must be capitalized, and only 10% of those costs can be deducted in 2022 (only a half-year’s write-off is allowed in year one). That means a deduction of only $200,000 and an increased taxable income of $1.8 million. For a C corporation paying taxes at 21%, that’s a tax increase of $378,000! It could be even worse for an S corporation or partnership with effective rates as high as 29.6% for its owners. For those entities, the cost could exceed $500,000.
Yes, it’s a timing difference, but that is quite a blow to cash flow for doing nothing different than you did the year before.
So, what are these R&D expenses that must be capitalized? Well, that’s a good question! The definitions in §174 are not very specific and basically say any costs incurred to perform your R&D function. Here is where much confusion comes into play as many equate these expenses to the commonly claimed Research and Development Tax Credit. While related, the definitions vary significantly. The R&D Credit is governed by Internal Revenue Code §41. §41 is much more restrictive than §174. Only very specific costs (mainly wages, supplies, and subcontractor costs) qualify for the credit. There is a reference in §41 to §174 noting that to qualify for the credit, the expenses must meet the definition of R&D expenses in §174. So, a reasonable interpretation is that any cost qualifying for the credit under §41 would be a subset of the much broader costs defined in §174.
A company would start with the costs that have been identified for the credit and then expand upon them to include related costs such as payroll taxes, fringe benefits, and other related firm overhead.
Will This Go Away?
Almost from the date of passage of TCJA, there has been discussion that these rules will be rescinded. Leaders from both sides of the aisle have expressed support for repeal and have even introduced legislation to do so. Unfortunately, none of this talk has translated into action yet, and the clock is ticking quickly on the extended due dates for 2022 tax returns. Congress has missed a number of opportunities to eliminate these rules. 2022’s failed Build Back Better Act included a provision to at least delay the effective date until 2026. Even though Build Back Better did not pass, Congress has had several other opportunities to take action, such as 2022’s Inflation Reduction Act, the year-end spending package, and, most recently, the Debt Ceiling resolution. Legislation was introduced in March 2023 to repeal these provisions in both the House and Senate, and there are numerous co-sponsors of the legislation in both Chambers, yet still no action.
We are not giving up hope that Congress will eventually find the right legislative vehicle to take action and/or that the IRS finally releases the long-awaited guidance to help us make our calculations. We just don’t know when this will happen. With tax filing deadlines quickly approaching, companies will soon need to decide on how to comply.
What Do We Do?
2022 passthrough entity (S Corporation, Partnership) tax returns are due under extension on September 15, 2023. C Corporation and Individual returns are due on October 16, 2023. The chances of the rules being repealed or at least delayed and/or the IRS issuing guidance by those dates are low.
That means tax returns must be filed using the tax rules in place at the time of filing, and those rules require these expenses to be capitalized and amortized. This answer is not the one everyone is looking for, but the IRS can issue significant penalties and interest for failure to follow the stated rules, which could make your tax bill even higher.
We have heard some say they will not claim the R&D Tax Credit and, as such, take the position that they do not have R&D expenses that meet the capitalization requirements. This position is an extremely risky one, especially if your company has a history of taking the credit in prior tax years. Even if you haven’t claimed the credit, numerous Federal Tax Court cases confirm that the work of numerous industries, including the AE and Manufacturing industries, qualify for the R&D Credit. Just being part of an industry that has a legislatively confirmed claim to the R&D Credit could severely damage your argument that these rules do not apply to your company. While we do not recommend this approach, if you choose to take it, we strongly encourage you to disclose this position while filing your tax returns.
Alternatively, we suggest you work with a knowledgeable firm to assist you with your required computations. This analysis includes a deep dive into your general ledger to understand your various expense buckets and to document why and why not specific expenses have been included in your computations. Once calculated, you can now assess the overall tax cost and what you can do to minimize it.
At a minimum, we believe this means continuing or, if you haven’t before, taking advantage of the R&D Tax Credit. If you haven’t taken the credit in prior years, consider performing prior year studies and capturing as many prior credits as possible. Remember, the credit is available for all tax years open under the statute, but the amortization rules do not begin until 2022. If the rules are not repealed, the credit helps offset the additional taxes; if they are repealed, the credit is enhanced cash flow for you.
In addition, conduct a thorough analysis with your tax advisor on other tax planning strategies you could utilize. This would include things like the many green energy incentives, with several new ones introduced by 2022’s Inflation Reduction Act, accelerated depreciation choices, method of accounting elections, and numerous other options that may fit your situation. Be sure not to overlook the impact on state income taxes and the related strategies for savings.
We also encourage you to continue telling your story to your representatives and encourage them to push for repeal. The voice of constituents with real-life stories of the impact of these provisions is powerful. Let them know how badly it hits your cash flow and how it disrupts your plans for job growth, capital expansion, etc.
Even if we do not get action by the filing deadlines, we must continue pushing for retroactive repeal after the deadlines and streamlined processes for promptly getting our tax payments back. Your voice is important, and we hope you will share your story.
Connect With Us
Stambaugh Ness’s Strategic Tax Advisory team stands ready to answer your questions, assist with your calculations, suggest planning strategies, and guide you through this challenging situation. Feel free to reach out to us and schedule a discussion. For those of you planning to attend the upcoming ACEC National Conference in Washington, DC, please contact Jen Nelson and plan to connect on-site.