To the dismay of many, the requirement to capitalize research and experimental (R&E) expenses, also referred to as research and development (R&D) expenses, under Internal Revenue Code Section 174 was not deferred in a 2022 year-end tax bill as many expected. This law change has far-reaching implications for U.S. businesses and innovation.
Prior to 2022, businesses had the option to either deduct their R&E expenses in the year they occurred or opt to capitalize and amortize these costs if more beneficial to the business. Additionally, the R&E costs could also generate tax credits.
The Tax Cuts and Jobs Act of 2017 (TCJA) made a significant change to Section 174 which went into effect for tax years beginning after December 31, 2021. Beginning with the 2022 calendar year, instead of deducting the R&E expenses in the year incurred, businesses must capitalize and amortize these costs.
The revised Section 174 rules for 2022 will require businesses to recover the capitalized expenditures ratably over 5 years beginning with the midpoint of the taxable year in which the expenditures are paid or incurred (a half-year of amortization will be allowed in the year incurred). If the expenditures are attributable to foreign research, the 5-year recovery period is extended to 15 years for the foreign research costs.
The TCJA also specifically added software development to the definition of R&E expenditures under Section 174. As a result, all software development costs must now be capitalized, regardless of whether the software is intended for internal or external use.
Under the TCJA changes, businesses must also continue to capitalize and amortize the R&E expenditures regardless of the “success” or outcome of the R&D project. This includes abandoned projects.
How Is the Research Tax Credit Affected?
If there is any consolation, the federal credit for increasing research activities (R&D tax credit) under Section 41 is not directly impacted by the Section 174 capitalization requirement. The TCJA amended Section 41 to define “qualified research” as research “with respect to which expenditures may be treated as specified research or experimental expenditures under Section 174.” This change essentially meant that for purposes of the R&D tax credit, the research expenditures were still the Section 174 R&E expenses paid or incurred during the tax year.
There’s still some hope that Congress will address this problem soon and restore full R&E expensing with retroactive effect back to January 1, 2022. However, hope is quickly fading as we approach the major tax deadlines in March and April, and Congress has not signaled an intention to take up the issue. Consequently, taxpayers are left with uncertainty and, in many instances, the prospect of a substantially higher tax bill this year.
For guidance in understanding the impact of the TCJA provision on your organization and how you can capitalize your R&E expenses, please contact any of the professionals at Dannible & McKee, LLP. Visit dmcpas.com to learn more.