Following the modifications to Internal Revenue Code Section 174 implemented by the Tax Cuts and Jobs Act (TCJA), specified research and development (“R&D” or “R&E”) expenses are no longer deductible beginning with the 2022 tax year. The elimination of the current-year SRE expenditure deduction will impose a significant tax penalty on many enterprises involved in research, engineering, manufacturing, product, and software development—potentially even if they had no taxable revenue before the Section 174 amendments.
What is an ‘SRE’?
Specified research and development expenditures are expenses incurred due to a company’s efforts to develop or enhance one or more products, processes, formulae, models, techniques, patents, innovations, software, etc. SREs are research and development costs if the activities are designed to uncover knowledge that will reduce confusion about creating or improving a product. In summary, if the taxpayer lacks a recognized competence or process for producing or upgrading a Product or its proper design, it stands to reason that the taxpayer will incur significant costs for each new product it seeks to bring to market.
Previous Rules (through 2021)
- Deduct R&E expenses in the current year;
- Choose to capitalize the costs and spread them out over a minimum of five years; or
- Choose an alternate option to spread out capitalized expenses over ten years.
Options for software development costs:
- Deduct the current year’s development costs, or
- After the development is finished, amortize the expenditures over five years.
- After implementing the program, amortize the three-year costs (bonus depreciation is also allowed).
New Rules (from 2022 tax year)
Capitalization and amortization of R&E expenses are required over the following:
- 5 years if carried out in the US,
- 15 years if it takes place outside of the US,
- Amortization doesn’t start at the end of the tax year; it begins at the halfway mark, and
- No deduction is permitted when something is sold, retired, or abandoned—not even for unsuccessful endeavors.
Changes with R&D Expense Treatment
- Section 174 SRE expenditures are a component of Section 41 (“R&D tax credit”) expenses. The handling of Section 41 expenditure deductions has changed starting in the ’22 tax year, even though the TCJA did not alter Section 41 since Section 41 expenses are subject to Section 174.
- In the past, businesses could deduct all SRE costs immediately, even Section 41 costs. A company’s current-year SREs are amortized and capitalized over five years for domestic costs and fifteen years for foreign expenses under Section 174, significantly lowering the permitted expensed amount.
- Expense 100% of SREs in the current tax year is now mandatory. If you work on software development projects or conduct research and development, you have to classify your costs as Section 174 expenses and follow the new amortization guidelines. This may significantly lower your total company deductions and may raise your taxable income for the year. It may also result in a situation where your firm has taxable income even when it isn’t making any cash-basis earnings or having enough real cash flow to cover its taxes.
- Whether the expenses were paid before or after July 1, 2022, the new amortization period starts at the middle of the taxable year in which §174 costs are first incurred. Since this is a “Half-Year Convention,” only 10% of 2022’s expenses may be written off.
- The R&D tax credit computation is still based on the same concept of Qualified Research Expenses, or “QREs.”
Broader scope for Sec 174
A far more comprehensive range of expenses is permitted by Section 174, including patent attorney fees, rent, utilities, and depreciation on materials and equipment used in research and development. The strict 4-part criteria still have to be met by QREs claimed under Section 41, even if the TCJA revisions made it essential to classify all R&D-related costs under Section 174.
Difference between Section 174 SREs and Section 41 R&D costs
To guarantee that their costs are correctly classified, all firms should communicate closely with their accountants.
Section 174 Covers All Expenses Associated With Software Development
Software development costs incurred after December 31, 2021, are mainly targeted by the TCJA since Rev. Proc 2000-50 no longer allows their tax deduction. Software businesses will thus need to make cautious plans.
- Must distinguish between software development costs located in the United States and abroad.
- R&D expenses connected to software development cannot be written off in the year incurred or paid.
- Software development expenditures must be spread out over 15 years for overseas spending and 5 years for domestic expenses.
- Should budget for higher income tax payments.
Let Us Help You
Section 174 eliminates the option that firms had previously had to deduct expenditures linked to research and development in the current year. This might result in a significant rise in income tax for companies that carry out research and development. For businesses involved in software development or research and development, the R&D tax credit offered under Section 41 remains one of the most excellent options to lessen or balance this possible tax rise. As of tax year 2022, the TCJA increased the value of the R&D tax credit for taxpayers in many ways.
Although tax changes might be frightening, we can assist you. Contact the National Tax Group to remain informed and effortlessly handle tax modifications. Schedule a call today!