There have been many uncertainties and questions regarding the treatment of Internal Revenue Code (IRC) 41, Credit for Increasing Research Activities, as changes to IRC 174, Amortization of Research and Experimental Expenditures, came into play in tax year 2022. Although both Internal Revenue Code sections cover research and experimental (R&E) expenditures, IRC 174 covers a broader scope of expenditures that require capitalization than the qualifying expenses for the IRC 41 income tax credit. Failure to understand the intersection of these rules and lack of planning may result in surprise income tax bills and underpayment penalties for taxpayers.
When engaged in the development or improvement of a product or process, IRC 174 covers an expansive set of costs that companies incur. Like IRC 41, IRC 174 direct costs may include:
- Wages,
- Supplies,
- Computer rental (cloud computing), and
- Third-party contractor costs directly associated with the R&E activity.
While the costs noted above must be capitalized and amortized under IRC 174, they may be eligible for Research and Development (R&D) tax credits under IRC 174 if the expenses were incurred within the U.S. (and within California for California credit purposes).
However, as outlined in Notice 2023-63, some IRC 174 indirect costs requiring capitalization that are NOT eligible for the IRC 41 R&D tax credit may include, but are not limited to:
- Cost of obtaining a patent such as attorney fees,
- Overhead and Administration costs (rent, utilities, depreciation, payroll taxes, benefits, etc.),
- Travel costs for the performance of specified research or experimental (SRE),
- Research after commercial production, and/or
- Adaptation of existing product to a particular customer’s needs.
Furthermore, Companies that are required to capitalize costs under IRC 174 must pay attention to where the costs were incurred. Costs incurred outside of the U.S. are subject to a 15 year-amortization period whereas costs incurred in the U.S. are subject to a 5-year amortization period.
When computing taxable income, taxpayers must consider their research and experimental costs that have to be amortized and how this may create taxable income for them. Companies with historical Net Operating Losses (NOLs) may not be able to fully offset the current taxable income due to the 80% limitation imposed by the Tax Cuts and Jobs Act and/or because of IRC 382 Ownership Change limitations.
Because of this potential income tax liability, it is important for taxpayers to review their research and experimental activities and actively monitor their eligibility for R&D income tax credits as these credits may reduce or eliminate income tax liabilities.
It is important for taxpayers to take proactive measures by developing a strategic methodology to comply with the IRC 174 capitalization rules while also maximizing R&D income tax credits under IRC 41.
Joyce Kandt, principal, leads the firm’s tax credits and incentives practice. Contact Joyce today regarding your eligibility and for an assessment of potential credits.
Aura Advisors is a boutique tax consulting, compliance, and representation firm working with affluent individuals and owners/officers/founders of start-up/emerging growth companies. Building connections beyond the code.