Planning for Major Research or Experimental Expenditures Changes Effective in 2022
Research or experimental expenditures, commonly referred to as “research and development” (or R&D) expenses are often significant for manufacturers. Prior to 2022, businesses had the option to either deduct their research or experimental expenses or could opt to capitalize and amortize these costs if more beneficial to the business. Additionally, the research or experimental costs could also generate tax credits (federal Credit for Increasing Research Activities or R&D tax credits) for manufacturing businesses.
The Tax Cuts and Jobs Act (TCJA), which was signed into law on December 22, 2017, made significant changes to corporate and individual tax laws. Why is the TCJA worth mentioning nearly five years later? The TCJA contained a delayed provision effective for tax years beginning after December 31, 2021, where businesses must capitalize and amortize their research or experimental costs beginning with the 2022 calendar year.
Effective for 2022, all businesses will no longer have the option to deduct research or experimental expenditures in the year incurred. Rather, Section 174 of the Internal Revenue Code, effective for tax years beginning after December 31, 2021, will mandate all businesses to capitalize and amortize these costs. The revised Section 174 rules for 2022 will require businesses to recover the capitalized expenditures ratably over the 5-year period beginning with the midpoint of the taxable year in which the expenditures are paid or incurred (a half-year of amortization will be allowed in the year incurred). If the expenditures are attributable to foreign research, the 5-year recovery period is extended to a 15-year period for the foreign research costs.
With the general nature of research and development, not all R&D projects result in “success,” and the R&D project is typically abandoned. What happens to these costs under the new 2022 rules? Under the TCJA changes, the business must continue to capitalize and amortize the research and experimental expenditures regardless of the success or outcome of the R&D project.
For a lot of manufacturing businesses, these rules will clearly not be a welcomed change. If there is any consolation, manufacturers should not see much of a change in the actual federal Credit for Increasing Research Activities in 2022. The TCJA did make changes to Section 41, which governs the R&D tax credit, which provides that “qualified research” will not mean research “with respect to which expenditures may be treated as specified research or experimental expenditures under Section 174.” This change essentially means that for purposes of the R&D tax credit, the research expenditures will still be the Section 174 research or experimental expenses paid or incurred during the tax year.
The TJCA changes to research and experimental expenditures will certainly have an impact on businesses that incur these types of expenditures. There is bipartisan support in both the House and the Senate to delay or entirely repeal the changes to the Section 174 capitalization requirement. However, it is uncertain if any legislative changes will happen in this area. The original “Build Back Better Act” included a provision that would have delayed the required capitalization of Section 174 costs until 2026; however, the Build Back Better “light” bill that the Senate ultimately passed (Inflation Reduction Act of 2022) and was signed into law on August 16, 2022, did not contain the provision to delay the effective date of the required Section 174 costs capitalization.
Often, at year-end, Congress will attempt to pass year-end “extenders” and modifications to expiring tax provisions, but until legislation is formally passed, these changes are here and in effect for 2022.
Contributing author: Brian J. Potter, CPA, CDA, is a tax partner at Dannible & McKee, LLP. Brian has over 16 years of experience providing tax and consulting services to a wide range of clients. He has extensive experience in individual and corporate tax planning, financial planning, multi-state taxation, research and development tax credits, New York State income tax credits and ownership transition advisory.