We have made it to 2023. While the holiday season filled with family, friends, and food has ended, our second favorite time of year is here: tax season! Our tax experts have prepared all year for this and now we are here to help our clients work through tax season as smoothly and efficiently as possible. One of our specialties, the R&D tax credit, is up for many changes this year and may require changes to your 2022 tax return. Let our R&D tax credit experts run you through the changes and updates you can expect when filing your returns.
Changes to R&D Tax Credit
Before the Tax Cuts and Jobs Act (TCJA) went into effect on January 1st, 2018, the Internal Revenue Code Section 174 allowed the deduction of certain research or development expenses in the taxable year that these R&D expenses were incurred. However, this has since been amended by the TCJA. Specified research or developmental expenses are not deductible for tax years after December 31, 2021, per Section 174(a)(1). Instead, these expenses must be charged to a capital account and amortized over 5 years.
To prepare for the switch from deductibility to amortization, the IRS has given taxpayers a procedure for how to handle R&D expenses on their 2022 tax returns. Revenue Procedure 2023-11 provides a method to obtain automatic consent under Section 446 to change methods of accounting for specified research and development expenses under Section 174, as amended by the Tax Cuts and Jobs Act.
How The Accounting Method Changes
The change to amortization under Section 174 should be treated as a change in the method of accounting as per Section 481 initiated by the taxpayer. This change is made on a cutoff basis for any R&D expense paid or incurred in the taxable years starting after December 31, 2021, meaning that adjustments to Section 481(a) are not required. Under the cut-off method, items arising on or after the cutoff date are the only items to be accounted for under this new accounting method. Please note that items arising before the year of change (December 31, 2021), can continue to be accounted for under the previous method of accounting.
To comply with the amended Section 174 and the change in method accounting, a statement with the taxpayer’s original federal income tax return for the first taxable year that Section 174 is effective should be filled. The taxpayer does not need to file a Form 3115, also known as an Application for Change in Accounting Method unless there has been a change in the method of accounting for R&D expenditures in a taxable year subsequent to the taxable year of the taxpayer in which Section 174 becomes effective. Therefore, for changes made in subsequent tax years, a modified Section 481(a) adjustment is required. The taxpayer would then need to file a statement with their original income tax return for 2022 to apply the method change on a cutoff basis.
What Does This Mean for You?
All of the changes made to the R&D credit this year make it a good time to reevaluate your company’s R&D strategy as we move about from deductibility to amortization.
- Section 41 or Section 174: Due to immediate deductions no longer being available under Section 174, businesses should shift their attention to Section 41 which provides a credit for increasing research activities. Taxpayers who were previously deducting R&D expenses under Section 174 will likely be eligible for the first prong of Section 41 for consistent research activities. Taxpayers with a taxable income should consider the documentation strategy for eligibility of Section 41 as it may be more valuable to them than an amortizable expense under Section 174.
- Amended Returns: Revenue Procedure 2023-8 requires an accounting method change to comply with the amended Section 174 either on the cutoff date of December 31, 2021 or on a modified cutoff basis in the taxable year after the first taxable year on this date. This provides taxpayers with the ability to file an amended return.
- Domestic vs Foreign Research: Under Section 174, the length of amortization varies depending on whether the R&D expenses are domestic or international. Domestic amortization is set to be 5 years, however, technology and web developments may blur the lines between foreign and domestic research.
- Audit Risk: The Inflation Reduction Act helped fund further IRS enforcement of tax laws and regulations. Those who are wanting to claim a credit under Section 41 should review their claims diligently and prepare for filing season as soon as possible. If you are planning on substantiating a credit for research expenses as part of Section 41, it is imperative to have documentation detailing the process of your research and experimentation.
While the intricacies of the changes in R&D expenditures on your 2022 taxes can be quite confusing, we are here to help. If you have any questions or concerns about filing season or the R&D tax credit, please contact one of our tax experts today!