Starting this year, the Research and Development (R&D) tax credit will undergo a significant change — and it may come as an unpleasant surprise for participating businesses. Historically, businesses could either deduct eligible R&D expenses from their taxable income for the filing year, or they could amortize their qualifying R&D expenses. However, the Tax Cuts and Jobs Act (TCJA) of 2017 included a change to take effect mid-2022: businesses will no longer have the option to deduct expenses. Instead, domestic R&D expenses will amortize over five years, and international expenses over fifteen years.
At the National Tax Group, we specialize in complex incentive programs, and we know R&D taxes inside and out. Our national tax experts will walk you through everything you need to know about this change, and how it could affect your business. Let’s start from the beginning…
What Is Amortization?
To understand the ramifications of TCJA, we have to first understand amortization. Amortization is the process of spreading the capital expenses of an intangible asset incrementally over a set period of time. This allows businesses to take tax deductions for the expense over a longer time frame, reducing their tax burden. It also links the cost of using the asset with the revenue gained from the asset, creating a more complete picture of the asset’s value consumption.
The process is very similar to the depreciation of tangible assets. For example, a company purchases a new piece of equipment that is expected to last for five years. Rather than recording the entire price of the equipment the year it is purchased, the company spreads out the cost over those five years. This lets them know how much value the equipment lost each year — if the declining asset value isn’t subtracted from yearly profits, the company may overpay on taxes and underestimate their costs.
Amortization follows a similar process, but with intangible assets like permits, trademarks, and of course, R&D expense deductions.
How Does Amortization Affect R&D Tax Deductions?
While amortization works in a company’s favor in most cases, amortization of R&D tax deductions puts businesses at a disadvantage. Previously, if a company spent $300 on qualifying domestic research and development each year, they could subtract $300 from their yearly taxable income. After the TCJA, that $300 must be amortized over five years — so each year, they can only subtract one-fifth of their investment ($60) from their taxable income. If the expenses were international, they would only be able to deduct one-fifteenth of their costs ($20) incrementally for fifteen years.
Companies that invest annually in research and development can still earn a new amortized deduction each year. Eventually, over either five or fifteen years, the fractioned deductions will add up to the original $300. However, until they reach that point, companies will face a sharp increase in their tax burden.
Why Does TCJA Require Amortized R&D Tax Deductions?
The changes to R&D tax deductions are just one part of TCJA, and a delayed one at that. The Act was signed into law in 2017, and it included changes such as lowering individual income tax rates, increasing standard deduction, and other modifications to business deductions and expenses. Amortizing R&D tax deductions provides a short-term increase in federal tax revenue, which helps pay for the Act’s expenses, and the different domestic and international amortization timelines incentivize research and development projects to relocate to the United States.
There have been several attempts to postpone or eliminate the new requirement, such as the Build Back Better Act’s proposed delay until 2025, but there is no guarantee the measures will pass. Instead, the best option is to be prepared.
How to Maximize R&D Value Under TCJA
If mandatory amortization could strain your company’s funds, consider the following options:
Review Costs Classified as R&D
In previous years, it was in a company’s best interests to classify all eligible expenses under research and development. Under TCJA, it’s not as clear-cut a decision. Revisit your expenses and consider each item’s classification — there may be an alternative tax treatment that offers a better value for your business.
Relocate International Research and Development Projects to the United States
This option may not be feasible for all companies, but it is worth consideration. International R&D expense deductions amortize over a fifteen-year period compared to five years for domestic R&D. This means that even with continual yearly R&D, your company won’t return to your original deduction amount for fifteen years. Relocation can be costly, but for some companies, it could be a better value in the long run.
Claim the R&D Tax Credit
Expense deductions aren’t the only way to earn tax benefits for your research and development projects. The R&D Tax Credit offers reimbursement for business activities and resources that were utilized during the research. Find out if your project qualifies with the R&D Tax Credit 4-Part Test:
- Permitted Purpose: The research activities are done to improve the quality, function, or reliability of a process or product.
- Technological Uncertainty: The activities must identify information to remove ambiguity in the development or improvement of a production process.
- Systemic Process: The activities must involve stimulation, logical trial and error, assessing alternatives, and refining hypotheses.
- Technological in Nature: The research done relies solely on physical sciences, biological sciences, computer sciences, or engineering.
Consult a National Tax Expert
Schedule a consultation with a national tax specialist to formulate a plan moving forward. Whether you’re looking for guidance in understanding the impact of the TCJA provision, assistance with claiming the R&D Tax Credit, or suggestions for other money-saving tax opportunities, National Tax Group can help you succeed. Our team has over 20 years of combined experience with complex tax benefits, from cost segregation studies to R&D tax credits. Contact us today for a free assessment.