- Although Section 174 capitalization and Section 280C changes primarily impact federal income tax, there are also state income tax considerations.
- Understanding state conformity to these federal requirements is essential in determining the state income tax impact of these changes.
- State income tax opportunities may be available for certain taxpayers affected by the updated capitalization requirements under Section 174.
Struggling with complex research expense calculations or state conformity issues?
With the recent issuance of IRS Notice 2023-63, addressing the capitalization and amortization requirements of research expenses for federal income tax purposes, now is a good time to focus on how states have reacted to the new capitalization rule.
State income tax opportunities may be available for certain taxpayers affected by the updated capitalization requirements under Section 174. Having a solid tax plan can help you prepare for the potential impact to your organization and bring tax savings opportunities to a complex situation.
What are the impacts of recent changes?
Historically, Internal Revenue Code (IRC) Section 174 allowed taxpayers to deduct research and experimentation (R&E) expenditures in the year they were incurred. Alternatively, taxpayers could instead elect to capitalize and amortize their R&E expenditures.
The Tax Cuts and Jobs Act of 2017 (TCJA) made a significant change to Section 174 for taxable years beginning on or after January 1, 2022. Now, taxpayers must capitalize and amortize these R&E costs and don’t have the option to deduct the expenses. The amortization period is five years for domestic expenses and 15 years for foreign expenses. On September 8, 2023, the IRS issued Notice 2023-63, Guidance on Amortization of Specified Research or Experimental Expenditures under Section 174, which provides guidance on the new capitalization rule and announces that the IRS intends to follow up the Notice with proposed regulations.
Generally, determining state taxable income begins with how a state adopts the IRC and how the state applies federal changes to its taxable income computation. Some states use “rolling conformity,” where they automatically adopt changes to the IRC as they occur. “Static” or “fixed date” conformity states adhere to the IRC as it existed at a specific point in time. Other states conform to the IRC selectively, referencing some federal provisions or definitions in their own tax code.
Noncomforming states leading the way
Most states have conformed to the Section 174 changes either due to rolling conformity, static conformity that includes the 2017 TCJA, or selective conformity that adopts Section 174. This means that when determining state taxable income, Section 174 expenditures must be capitalized and amortized over the same period as they are for federal income tax purposes.
However, there are exceptions, including some states that enacted legislation that does not follow the federal treatment under Section 174.
California generally adopts the IRC as of January 1, 2015, which would not include the changes to Section 174.
On May 2, 2023, Georgia enacted S.B. 56 and decoupled from the federal treatment under Section 174. Section 174 must be applied as it was in effect immediately before TCJA was enacted.
On May 4, 2023, Indiana enacted S.B. 419, which requires a deduction for R&E expenditures that were required to be capitalized for federal purposes and an addition for any R&E expenditures deducted for federal purposes — effectively decoupling from the federal capitalization treatment under Section 174.
For tax years beginning on or after January 1, 2022, Tennessee follows the federal treatment of expenditures under IRC Section 174 as it existed on December 31, 2017.
Wisconsin adopts Section 174, but specifically states it is the version that existed prior to TCJA.
How might other states follow?
States using the current federal income tax rules to govern their state income tax rules have been slow to enact legislation that goes against federal treatment. Some have been hesitant to decouple from the federal capitalization rule under the premise that Congress would be repealing it.
Now that it appears Congress is unlikely to repeal the capitalization rule (at least for 2022 and maybe 2023), states need time to determine the fiscal impact of decoupling and whether it could further entice companies to perform research activities in their states. It is likely that more states could enact decoupling laws in upcoming legislative sessions.
Additional state income tax opportunities may exist
The TCJA also amended IRC Section 280C(c). Formerly, IRC Section 280C(c)(1) required a taxpayer to reduce its Section 174 deduction by the amount of its federal research and development (R&D) credit — unless the taxpayer elected a reduced federal credit. The TCJA removed this language but left the portion of Section 280C(c) relevant to capitalizing and amortizing R&E expenditures.
Specifically, Section 280C(c)(1) states if the amount of the R&D credit exceeds the amount of qualified research expenses allowable as a deduction, the amount chargeable to a capital account shall be reduced by the excess. Like Section 174, not all states conform to Section 280C. Therefore, where IRC Section 280C(c) is implicated for federal income tax purposes, a company needs to consider its effect on its state taxable income. Some states may allow for a subtraction modification with respect to a Section 280C(c) federal adjustment (when it increased federal taxable income).
How we can help
It is important to understand federal conformity on a state-by-state basis, for both Section 174 and Section 280C, in order to correctly treat R&E expenditures on state income tax returns.
CLA’s state and local tax professionals understand the complex tax laws across the states and jurisdictions where your company does business. We can help with all aspects of R&D incentives — such as quantifying the state tax benefit available, identifying state income tax opportunities arising from state non-conformity rules, and planning for future expansion into new states.
In addition, our R&D credit specialists can assist your organization with enhancing research expenses and the federal and state tax credits that go along with them.