The Change to Mandatory Capitalization of R&D Costs Affects Businesses NowNov 01, 2022 03:56PM ● By Adam Quattlebaum
While the U.S. tax code is always changing, there are many provisions that remain the same for years, even decades. When these seeming constants do change, it can be difficult for taxpayers — including businesses – to adjust in a timely manner.
A great example happening now is the change to how research and development (R&D) costs are treated for tax purposes. If businesses are not already planning for this, they should be. The changes to R&D costs impact most taxpayers across many industries.
You might initially only think of manufacturing and technology companies, which have significant costs that are considered R&D costs. But due to the integration of technology in virtually every business, these changes may impact many other industries such as banks, retailers, service providers, and the like.
First, a definition of R&D costs under Internal Revenue Code (IRC) Section 174. R&D costs are expenditures incurred in the experimental or laboratory sense that are intended to eliminate uncertainty. Any and all software development costs (internal or external use) are considered R&D costs under Section 174.
Examples of such activities that fall under Section 174 include new product development, product improvement, process development, process improvement, all software development, process automation, engineering activities, and more. Section 174 generally includes all such costs incident to the development or improvement of a product (direct costs and indirect costs such as overhead, utilities, rent, and depreciation.)
Since 1954, businesses have been able to deduct these costs in the year incurred, making it a well-accepted tax benefit for R&D investment. The 2017 Tax Cuts and Jobs Act included a provision that sunsets this longstanding provision, which means taxpayers are now losing the ability to deduct such costs immediately. Instead, they are required to capitalize and amortize U.S.-based R&D expenses over a period of five years (15 years for foreign R&D expenses), and they cannot recover these costs before the end of the amortization period, even if sold or abandoned. This results in an increase to the current tax liability of taxpayers.
Many taxpayers have delayed the adoption of these new requirements, potentially exposing themselves to underpayment penalties because of the possibility or expectation that Congress will step in and repeal the current law or delay its effective date. Many taxpayers expect a deferral or extension given the potential pain point for taxpayers and broad bipartisan support for R&D incentives.
But counting on Congress has never been a sure bet, which is why we have guided our clients to plan accordingly for the R&D deductibility changes. In practice, that means modeling the impact to your tax liability, adjusting your quarterly tax payments if necessary, so you are not left with a surprise payment at the end of the year and, or worse, a penalty for underpaying. In short, if you have R&D expenditures for the 2022 tax year, you should expect your tax liability to increase. You should also avoid a double whammy of a penalty on top of that.
One of the first steps we recommend to our clients, which include a number of manufacturing and technology firms here in upstate South Carolina, is to model the impact of these changes to your estimated tax payments and financial statements since these additional tax payments will affect cash flow. This means carefully identifying and quantifying your qualifying R&D costs.
Regardless of what Congress may or may not do, the time is now for impacted businesses to begin planning, modeling, and evaluating the impact of these new rules.
Adam Quattlebaum is a tax partner based in Greenville at FORVIS, a top 10 accounting and advisory firm created by the merger of DHG and BKD. He leads the firm’s Research & Development tax credits practice and has extensive experience defending and successfully sustaining R&D tax credits through IRS and state audits. Contact him at [email protected].
This article is for general information purposes only and is not to be considered as legal advice. This information was written by qualified, experienced FORVIS professionals, but applying this information to your particular situation requires careful consideration of your specific facts and circumstances. Consult a professional at FORVIS or legal counsel before acting on any matter covered in this update.