Companies that have relied on the research & development tax credit to lower taxes and recoup some of the costs related to R&D activities will find this year’s tax season difficult and likely more expensive.
A new rule requiring R&D-related costs to be capitalized and amortized became effective for R&D-related costs incurred after December 31, 2021. This means many of the expenses that previously qualified for the R&D credit – which allowed taxpayers to immediately recover qualified costs – now will have to be amortized over five years. Any foreign R&D expenditures will be amortized over 15 years.
While the R&D tax credit still exists and no changes have been made to the credit itself, the application of the credit is now largely offset by this amortization requirement.
The impact of this new rule will fall most heavily on manufacturers, software developers and other companies that engage in sustained R&D activities.
Background
The R&D tax credit was enacted in 1981 to address concerns that U.S. economic performance had fallen below its potential. In 2015, Congress made the credit permanent. But two years later, the Tax Cuts and Jobs Act of 2017 was enacted, including the capitalization and amortization rule, which would help pay for other features of the TCJA.
The capitalization and amortization rule didn’t get widespread attention when TCJA passed in 2017 because it wasn’t scheduled to take effect for another five years.
The bill is now due. While a legislative effort was made in Congress last year to reverse this rule, the legislation did not pass. Whether Congress will act this year to reverse the rule retroactively remains to be seen.
Even with the R&D credit available, the option has always been there to elect to capitalize and amortize R&D costs. But no one ever used it since it was better to get the immediate deduction of the R&D costs.
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:
1. Permitted purpose
R&D activities must develop or improve the functionality, performance, reliability or quality of a new or existing business component (product, process, software, technique, formula or invention).
2. Elimination of uncertainty
The development or improvement of the business component must seek to discover information that would eliminate uncertainties about its appropriate design or the capability or method of its development.
3. Process of experimentation
Taxpayers are required to identify technological uncertainty and then properly evaluate one or more alternatives to eliminate it.
4. Technological in nature
Experimentation has to rely on the principles of engineering, physical or biological science, or computer sciences and seek to discover information that is technological in nature.
Under the new rule, an activity may meet only two 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.
For example, a $50,000 expenditure on attorney fees related to an R&D project would have to be capitalized under the new rule, whereas it would not previously.
Additionally, the amortization begins at the mid-point of the year in which the expense was incurred. So, if you had $100,000 in R&D expenses for 2022, you could only deduct $10,000 instead of $20,000 (20% of the total) for the first year.
What to Do Now
As a result of the new rule, companies that never would have qualified for the R&D credit now will have to evaluate whether they have incurred R&D type expenses that would be captured by the capitalization and amortization requirement.
Companies that have traditionally taken the R&D credit will be significantly impacted and should prepare for what will happen when those tax benefits are added back into their expenses. An effective way to prepare would be to look at their previous couple of years’ Form 6765 Credit for Increasing Research Activities to see what the R&D expenses were. Line 28 “Total qualified research expenses” provides an idea of what the impact of the new rule will be.
Will the Rule be Reversed?
There is significant bipartisan support in Congress for reversing this rule, and it’s not out of the question that Congress could act this year to retroactively eliminate it. Consequently, some taxpayers who will be disadvantaged by the rule may want to consider going on extension and waiting to file their tax returns until September, in case retroactive legislation is enacted. Getting an extension is a particularly good idea for companies that have traditionally gotten R&D tax studies.
In the end, though, you can only work with the laws that are on the books. Even if you get a tax filing extension, you still must pay your expected taxes in March or April, depending on your entity type. If retroactive action is taken in Congress, you would get some of that payment back after you file.
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, in this case it appears most states will follow the federal government’s lead. So, taxpayers will deal with the same issues at both the state and federal levels this year with regard to R&D expenses.
If you would like to discuss the impact of the new R&D tax rules on your company, contact your KRD advisor.
