Recent Changes to Research and Development Expenditures May Affect Your Manufacturing Company
The Tax Cuts and Jobs Act (TCJA) of 2017, amended numerous longstanding tax provisions of the Internal Revenue Code of 1986. Many of the enacted provisions became effective for tax years beginning January 1, 2018, such as the reduction in the corporate tax rate to 21%, the increase of the standard deduction for individual filers and the newly implemented qualified business income (QBI) deduction for owners of pass-through entities.
Several other provisions were delayed for future years. One provision that was delayed under the TCJA was the amortization of research and experimental (R&E) expenditures under Internal Revenue Code Section 174. The purpose of this article is to inform manufacturers of the significant changes to Code Section 174, its effects on taxable income and strategies for reducing the tax burden ultimately associated with these changes.
Before the TCJA, taxpayers incurring R&E expenses were allowed to treat these expenses in one of four ways:
- the expenses could be currently deducted under Code Section 174(a);
- the expenses could be capitalized and then amortized over a period of not less than 60 months under Code Section 174(b);
- the expenses could be charged to the capital account under Regulations Section 1.174-1; or
- the expenses could be capitalized and amortized ratably over 10 years under Code Section 59(e).
As a result of the changes brought on by the TCJA, for tax years beginning after December 31, 2021, the option to deduct these expenditures has been eliminated. Therefore, it is imperative that manufacturers understand the changes and how they affect their taxable income.
Under the TCJA, taxpayers who previously utilized Code Section 174(a) to expense these costs are now required to capitalize and amortize these costs over five years for domestic expenses and 15 years for foreign expenses. Furthermore, for the year the expenses are paid or incurred, they are required to be placed in service at the midpoint of the tax year resulting in only a half-year of amortization for the first year. For example, if a taxpayer had taxable income of $1,000,000 and domestic qualified Code Sec. 174 R&E expenditures of $100,000, before January 1, 2022, the taxpayer could expense the $100,000, resulting in taxable income of $900,000. However, for tax years beginning after December 31, 2021, taxpayers are no longer able to deduct the $100,000 of qualified R&E expenses and must now amortize these costs over five years. As a result, the previous deduction of $100,000 has now been decreased to only $10,000, a difference of $90,000 in taxable income.
In addition to the changes to Code Section 174, taxpayers incurring R&E expenditures should also be aware of the potential tax savings opportunities surrounding Code Section 41, more popularly known as the federal credit for increasing research activities (R&D tax credit), and the election to utilize the reduced credit under Code Section 280C(3). However, as with many tax decisions, variables such as your organization’s current tax position, the possibility of tax rates rising soon and the potential elimination of deductions such as QBI, should be considered when choosing which variation of the credit is most beneficial for your organization.
As with many tax laws, understanding the complexities of the law can be troublesome for many manufacturing companies. Therefore, before undertaking any action related to new changes related to research and development, we recommend contacting a CPA, like the professionals at Dannible & McKee, LLP.
Contributing author: Sean R. Conners, CPA, is a tax manager who has five years of experience in individual and corporate taxation and tax planning. Sean also specializes in multi-state taxation and concentrates on the manufacturing industry. For more information on this topic, you may contact Sean at email@example.com or (315) 472-9127.