By: Jamie Baker, CPA
Key Takeaways:
- The federal tax provision that gutted the Research & Development tax credit took effect last January and Congress has failed to repeal it.
- This new rule requires capitalization and amortization of R&D costs over 5 or 15 years.
- The impact is most felt by manufacturers, technology, and biotech companies that sustain long-term research projects.
- Most states, including Illinois, have R&D tax credit laws mirroring federal practice.
- A few states have “decoupled” from the new federal R&D rule, including California, Georgia, Indiana, Mississippi and Wisconsin, as well as Texas (limited decoupling).
When the federal tax provision that gutted the research-and-development tax credit took effect last January, few business taxpayers panicked. Conventional wisdom suggested that Congress would repeal that portion of the Tax Cuts and Jobs Act (TCJA) before the damage was done. Many business taxpayers even filed an extension this year to give Congress time to roll back the law before filing their income tax returns.
They were disappointed.
Congress has not repealed the provision of TCJA that requires R&D-related costs to be capitalized over 5 or 15 years and amortized, and its failure to do so does not bode well for other provisions of the TCJA that will sunset over the next two years. Some of those provisions benefit large and small businesses and their loss would have widespread impacts.
The rule requiring capitalization and amortization of R&D costs was part of the TCJA, which was enacted in 2017, but it was one of many provisions that was timed to take effect several years down the line. Congress was under pressure to keep the cost of TCJA down, so it built in many provisions that would sunset as of December 31, 2025, and other provisions – generally those that would raise taxes – that would take effect several years after enactment.
Consequently, the next two years will see many tax provisions changing – either disappearing or taking effect – in ways that will disadvantage many businesses.
R&D Tax Credit
The new rule requiring capitalization and amortization of R&D-related expenses does not do away with the R&D tax credit. The credit still exists, but it is significantly less beneficial to taxpayers because the application of the credit is now largely offset by the amortization requirement.
The impact of the rule falls most heavily on manufacturers, technology and biotech companies as well as other industries that engage in sustained R&D activities.
The rule became effective for costs incurred after December 31, 2021, so business taxpayers felt the impact this year as they had to comply with an array of new accounting rules and recordkeeping required by the law, and subsequently were preparing their 2022 tax returns.
Complications
Complicating the situation was the failure of the IRS to issue guidance related to treatment of certain costs in specific industries. This left some in the software industry, for example, uncertain about how to quantify the time of a software developer. IRS guidance was not issued until September 8, 2023 in Notice 2023-23. .
Under the new law taxpayers must capitalize and amortize R&D costs whether or not they take the R&D tax credit. Moreover, the expenditures that are required to be amortized are broader than those that qualify for the R&D credit.
To qualify for the R&D credit, activities and expenses must meet four criteria set out in IRC Section 41. Under the new rule, an activity may meet only three of the four criteria, but would still be required to be capitalized, even though on its own it never would have qualified for the R&D credit. Consequently, taxpayers will find expenses on their books that are subject to five-year capitalization and amortization for the first time.
Now that a full tax season has passed with the rules in place, taxpayers should have a good idea what they’re up against next year in terms of R&D cost accounting and recordkeeping. It is likely that the capitalization and amortization rule will still be in effect next tax season. While a legislative effort was made in Congress last year to reverse this rule, the legislation did not pass. Whether Congress will act in the coming year to reverse the rule retroactively remains to be seen.
At the State Level
The majority of states – including Illinois – have R&D tax credits that mirror the federal credit. While states have the option of “decoupling” from federal practice when they have similar or identical tax laws, only a few states have specifically decoupled from the new R&D rule, including California, Georgia, Indiana, Mississippi and Wisconsin, as well as Texas, which has provided a limited decoupling.
So, collectively you can deduct expenses as you’ve normally done in the past. For example, if you capitalized $200,000 in R&D expenditures on your federal return, you can deduct those expenses on your state return and add back the amortization expense from your federal return. But given the federal amortization rule, there will be an adjustment on the state return for those amortization expenses for the next 5 years, or 15 years for R&D costs that are incurred abroad.
If you would like to discuss the impact of the new R&D tax rules on your company, contact your KRD advisor.
