The Tax Cuts and Jobs Act of 2017 (TCJA) requires capitalization of all research and development (R&D) expenditures incurred in tax years beginning after Dec. 31, 2021.
Historical Treatment of R&D Expenditures
Since 1954, the U.S. tax code gave businesses the option of deducting R&D expenditures either in the same taxable year in which they occur or amortized over a period of at least 60 months.
New Rules under TCJA
Starting in 2022, the U.S. tax code will no longer allow businesses to expense all qualified Internal Revenue Code (IRC) Section 174 expenditures in the year they are incurred. Instead, taxpayers will be required to amortize any such deductions over 5 years for domestic expenditures or over 15 years for expenses incurred offshore. Capitalization and amortization period would begin with the midpoint of the tax year in which the expenditures are paid or incurred. Taxpayers will also be required to amortize R&D expenditures for the 5 or 15 year period even if the related property is disposed of, retired, or abandoned during the amortization period. The disposition, retirement or abandonment does not accelerate the expense deduction.
To properly comply with IRC Section 174, taxpayers must be able to identify all R&D expenditures, which Treasury Regulations broadly define as expenditures incurred in connection with the taxpayer’s trade or business which represent research and development expenditures in the experimental or laboratory sense. The term generally includes all costs incident to the development or improvement of a product. Expenditures represent R&D costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not ascertain the capability, method for developing, or the appropriate design of a product. Whether expenditures qualify as R&D expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents. The success, failure, sale, or use of the product is not relevant in determining eligibility under IRC Section 174. Further, costs may be eligible if paid or incurred after production begins but before uncertainty is eliminated.
Internal Revenue Code Section 174 expenditures include (but not limited to):
- All software development costs
- Direct research costs such as wages, supplies, contract research
- Indirect research costs such as overhead and administration costs (rent, utilities, depreciation, payroll taxes, benefits, etc.)
- Cost of obtaining a patent such as attorney fees
- Testing products (not including ordinary QC)
- Developing and designing products/systems
- Improving products/systems
- Developing prototypes
- Validation testing
- Research after commercial production
- Research related to style, taste, cosmetic, or seasonal design factors
- Adaption of existing product to a particular customer’s need
- Reverse engineering
Capitalizing R&D expenditures that have previously been allowed as tax deductions may put many companies in a taxable income position and create tax liabilities. However, with proper planning and documentation of R&D activities, taxpayers may be able to offset taxable income with R&D tax credits.
Since Congress did not take any action before the end of the 2022 year, it is essential that companies prepare for the 2022 tax filing season. Start by developing a process to identify and track R&D expenditures (as defined under IRC Section 174) and separating them from other deductible expenses, possibly by using a departmental profit and loss method to track such costs. Taxpayers will no longer be able to aggregate R&D expenditures with other items that can be expensed (such as sales, general, and administrative expenses). This will likely be a significant undertaking for taxpayers to comply with the TCJA changes based on the broad and subjective nature of these provisions.
Please contact us if you would like to understand the tax implications of this change and discuss your eligibility to claim R&D tax credits.
Dana R. Borys, an Accountancy Corporation is a boutique tax consulting, compliance, and representation firm working with start-up/emerging growth companies and affluent individuals. Building connections beyond the code.