Filing season is in full swing! Taxpayers are now required to amortize research and development expenses over a 5 or 15-year time period beginning in 2022 or later. This change to amortization will affect a broad range of companies and also impact how taxpayers handle their tax returns and financial statements. With the legislative push still being debated in Congress, businesses should be working to identify the affected costs and asses the impacts.
What are Section 174 Expenditures?
Under federal legislation, research and development expenditures for Section 174 are expenses companies incur during the development or improvement of products or procedures. Typically, these costs are within activities that are trying to answer questions about the capability, methodology, or effectiveness of a design. This definition is broad and encompasses many different expenditures, however, it is important to thoroughly document these expenses. Section 174 is intended to include a wide range of industries, not just science and engineering.
Direct costs that may be included in Section 174 are wages, supplies, computer rental, or 3rd party contractors with a direct association with the R&D activity. Examples of indirect costs that may be included in Section 174 are rent, utilities, overhead, or attorney fees for patents. It is important to understand which costs are included as expenditures and which ones cannot be. Likewise, which are direct vs indirect in direct association with R&D activities. R&D tax credit specialists are able to help you differentiate between all expenditures and R&D expenditures.
How the Recent Changes Impact Finances and Tax Liability
The Tax Cuts and Jobs Act amended Section 174 for how the federal income tax treatment of R&D expenditures are paid or incurred for taxable years after December 31, 2021. Traditionally, companies may have deducted these costs for federal income tax purposes, the new changes require capitalization and amortization over a period of five years for domestic research and development and fifteen years for foreign R&D.
While some financial experts were expecting a change in legislation to restore R&D expensing, Congress failed to enact a deferral of this provision. Negotiations may continue this year, however, companies should plan to continue with their financial statements as the currently written law states. These new changes will result in new, and potentially material, book-tax differences and related deferred tax assets. In certain cases, the effective tax rates could be affected, especially where there are impacts on other tax calculations. Due to the challenges legislation often faces, companies should also prepare to account for this change for tax compliance, planning, and payment purposes.
How Does Section 174 Interact with Section 41 for the Research Tax Credit
As previously mentioned, Section 174 can encompass a wide range of expenditures, much broader than the definition of qualified research expenses for the Research Tax Credit (RTC) under Section 41. Qualified research expenses are usually only expenses directly related to research activities like domestic wages, supplies, and third-party contractor costs. Section 174 includes all of these but also many other expenses that are excluded from RTC. Many companies will have 174 expenditures even if they haven’t claimed the RTC in the past. However, companies will need to specifically identify Section 174 costs, as they are now subject to capitalization and will need to implement a different documentation approach.
Implementation and Maintenance Challenges
Companies should be prepared to establish a method for identifying and tracking R&D expenditures under Section 174. Due to the broad and subjective nature of this legislation, identifying these expenditures will likely be a significant undertaking. Many costs that were not traditionally thought of as “R&D” may be subject to Section 174. Even companies that may think they have a handle on the expenses will need to review their documentation.
The new amortization of the R&D tax credit can be quite confusing, our team of tax experts specializes in R&D. We are here to help with any questions you may have. Please contact us today for your free assessment.