- Capitalization of research and experimental costs under Section 174 could be here to stay since Congress could not agree on a legislative fix.
- Companies large and small will feel the impacts of smaller deductions and increased taxable income.
- The IRS has issued guidance instructing taxpayers how to report and implement this change beginning with tax year 2022.
- Evaluate how this law change will impact your tax and financial reporting positions.
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To the dismay of taxpayers and practitioners, the requirement to capitalize research and experimental (R&E) expenses under Internal Revenue Code Section 174 was not deferred in a 2022 year-end tax bill as many expected, adding more confusion and uncertainty to an already tricky situation.
Despite strong support in Congress to fix the Section 174 law change — and a vocal lobbying effort from industry groups — Congress could not come together to address this pressing issue. Even more worrisome is the fact the new divided Congress appears to be in no hurry to take up tax matters.
With billions in additional tax expense at stake, this law change has far-reaching implications for U.S. businesses and innovation.
Historically, Section 174 allowed taxpayers to deduct research and experimentation (R&E) expenses in the year incurred. Companies large and small that engage in research-based activities relied on full expensing as a significant cost recovery mechanism since Section 174’s enactment in 1954.
The Tax Cuts and Jobs Act of 2017 (TCJA) made a significant change to Section 174 that went into effect for taxable years beginning after December 31, 2021. The change completely eliminated the ability to currently deduct R&E expenses. Instead, taxpayers must now capitalize and amortize these costs.
The amortization period is five years for domestic expenses and 15 years for foreign expenses. Additionally, for the first year of the amortization period, the expenses are “placed in service” at the midpoint of the tax year. Thus, the deduction in year one is only half the amount it will be in subsequent years.
With billions in additional tax expense at stake, this law change has far-reaching implications for U.S. businesses and innovation
Recent IRS guidance
The IRS gave a sharp reminder recently that R&E expensing may officially be a thing of the past when it released Revenue Procedure 2023-8 (later modified by Revenue Procedure 2023-11) providing taxpayers with guidance as to how the law change needs to be implemented and reported for tax year 2022.
The guidance adds the Section 174 change to the IRS’s list of automatic accounting method changes taxpayers can make on Form 3115, Application for Change in Accounting Method. This method change is made on a “cutoff” basis, meaning that taxpayers implement the change with their first tax year beginning after December 31, 2021, without any adjustment for expenses incurred in previous years. However, should a taxpayer fail to adopt the new method in year one, a method change in a subsequent year will require a taxable income adjustment that considers R&E expenses arising in tax years beginning after December 31, 2021.
In lieu of a Form 3115, taxpayers are permitted to file a statement with their tax return for this first year of adoption only. The IRS will treat such a statement as a Form 3115 for purposes of the automatic method change procedures.
Who's impacted?Every taxpayer that has R&E spending is impacted by the law change. Section 174 contains no exceptions to the capitalization requirement. Whether a company has $10,000 in R&E, or $100 million, the costs must be capitalized.
|Tax Year 2021 - Full Expensing
||Tax Year 2022 - Capitalization and Amortization|
|Total income||$1,000,000||Total income||$1,000,000|
|Total R&E expenses||$250,000||Total R&E expenses||$250,000|
|R&E deduction in year one||($250,000)||R&E deduction in year one (10% of costs, mid-year convention)||($25,000)|
|Federal taxable income||$750,000||Federal taxable income||$975,000|
|Federal corporate tax rate||21%||Federal corporate tax rate||21%|
|Tax due||$157,500||Tax due||$204,750|
The same taxpayer, with the same facts, ends up paying 30% more tax in 2022 solely because of the Section 174 change. Undoubtedly, this will have an enormous impact on taxpayers in 2022 in the aggregate.
How is the research tax credit affected?
The research tax credit under Section 41 is not directly impacted by the Section 174 capitalization requirement. In many cases, the research credit will be even more important to help reduce the additional tax liability generated by the change in R&E treatment.
The research credit is based on a subset of expenses that fall under Section 174. In other words, Section 174 can be much broader in scope and applies to expenses not eligible for the research credit.
Consider the case of foreign-based labor: these costs do not qualify for the research credit but are still subject to capitalization under Section 174. Even worse, these costs will be amortized over 15 years as mentioned above. This whipsaw result will be all too common for U.S. businesses beginning in 2022.
There’s still some hope that Congress will address this problem soon and restore full R&E expensing with retroactive effect back to January 1, 2022. However, hope is quickly fading as we approach the major tax deadlines in March and April and Congress has not signaled an intention to take up the issue. Consequently, taxpayers are left with uncertainty and, in many instances, the prospect of a substantially higher tax bill this year.
What’s more, the Section 174 change is having serious ramifications for companies’ financial reporting positions. And to make the situation even more challenging, there are state tax issues involved, requiring taxpayers to review their state filing footprint and determine which jurisdictions adopt the change and which do not.
How we can help
Many taxpayers have never separately accounted for their Section 174 expenses, and this law change can seem like a daunting task. CLA’s R&D tax team can assist your organization in identifying your Section 174 expenses and preparing necessary accounting method changes. This can also be done seamlessly as part of a research tax credit study.
Contact a CLA professional to learn how we can help your organization comply with these new rules.