Major Changes to the Tax Treatment of Research and Experimental Expenditures Are Here
Historically, companies in the United States that engage in research and development (R&D) activities were afforded certain tax benefits. This included the ability to fully deduct certain R&D costs in the tax year incurred, as well as the ability to claim the Federal R&D credit. However, the Tax Cuts and Jobs Act of 2017 (TCJA) has changed the way these costs are treated from a tax perspective for tax years beginning after December 31, 2021. It is important that companies understand these changes and plan accordingly as the changes will generally result in increased taxable income.
The changes made by the TCJA apply to expenses described in Internal Revenue Code Section 174 which include expenses connected to research that is undertaken for the purpose of discovering information in order to eliminate uncertainty concerning the design and development of a new or improved business component or process.
For tax years prior to January 1, 2022, companies that incurred certain R&D costs were permitted to fully deduct these costs in the tax year incurred. Now, under the TCJA, certain R&D expenses incurred in tax years beginning after December 31, 2021, will need to be capitalized and amortized over a period of five years for domestic research and fifteen years for foreign research beginning with the month they first realize benefits from the expenditures. Furthermore, if any previously capitalized R&D expenses are abandoned, the expenses must continue to be amortized over the remaining five- or fifteen-year period.
In addition, software development costs will now be included in the definition of R&D costs under Section 174. Prior to TCJA, depending on the nature of the costs, software development expenses were either fully deductible in the year incurred or capitalized and amortized over thirty-six months from the date the software is placed in service. Under TCJA, software development costs incurred in tax years beginning in 2022, will also need to be capitalized and amortized over a period of five years.
As a result of the changes described above, many companies that incur R&D expenses and software development costs will experience an increase in taxable income. However, there are some strategies that can be used to mitigate the impact of these tax changes. These include:
- Perform a detailed review of the classification of certain costs, ensuring that only true R&D expenses are categorized as such.
- Use consultants and vendors based in the United States, if possible, when incurring expenses related to contracted R&D to avoid the longer fifteen-year amortization period.
- Take full advantage of the Federal R&D credit.
While previous versions of President Biden’s Build Back Better Act (BBBA) included a delay in the amortization of Section 174 until 2025, this has failed to move further in Congress. Companies should start proactively planning for the impact of this law change as early as possible in 2022 to mitigate some of the negative impacts discussed above. For further information or if you have questions about how these changes will impact your tax liability, feel free to contact Alex Nitka, CPA, at firstname.lastname@example.org or any of our tax professionals at 315-472-9127.
Contributing author: Alex J. Nitka, CPA is a tax partner at Dannible & McKee, LLP. Alex has over 13 years of experience in all areas of income taxation, including individual and corporate tax planning, financial planning, multi-state taxation, research and development, New York State income tax credits and ownership transition issues.