global Tax FAQs- Changes to Treatment of R&D Expenditures February 07, 2022 There are many questions about the TCJA changes in accounting for R&D expenditures that began 01/01/2022 and what Congress will do to change them. Did you read our blog Changes on the Horizon for the R&D Credit? While there is considerable pressure on the legislature to eliminate these modifications to the research and development (R&D) credit, given the current political environment, the repeal or delay may not take place quickly. So, when planning for 2022, taxpayers need to consider the law as it currently stands. Old Law Sec. 174 Before TCJA, taxpayers could choose to immediately expense R&D expenditures. Also, taxpayers who paid or incurred software development expenses could rely on Rev. Proc. 2000-50 and, due to the similarity of those expenditures with those under Sec. 174, the IRS would not disturb a taxpayer's treatment of these costs if consistently deducted or consistently capitalized and amortized. New Law Sec. 174 Beginning January 1, 2022, the TCJA eliminates the option to immediately deduct US-based R&D expenditures. Instead, it requires that they be charged to a capital account and amortized over five tax years, beginning with the midpoint of the tax year in which the expenditures are paid or incurred. For foreign research, the amortization period extends to 15 tax years. The TCJA also changed the language to add a special rule that states that for purposes of Sec. 174, any amount paid or incurred in connection with the development of software is treated as a "specified research or experimental expenditure." The new rule essentially removes the ability to use Rev. Proc. 2000-50 to immediately deduct software development expenditures. The modifications for the 2022 tax year will require taxpayers to change accounting methods, and the changes are executed on a cutoff basis. Therefore, taxpayers do not benefit from a historical adjustment for previously incurred R&D expenditures. See the example below assuming a tax rate of 25%: Old law New law, year 1 R&D Expenditures $100,000 $100,000 Tax Deduction $100,000 $10,000 Tax Savings $25,000 $2,500 How do these changes affect the R&D tax credit? This law change applies to taxpayers with R&D expenditures, regardless of whether the taxpayer claims an R&D credit. (Note that all expenses eligible for the credit will fall under section 174, but not all section 174 expenses qualify for the R&D credit). It will be necessary for taxpayers to have a sound system for tracking and preparing for the tax impact of no longer immediately deducting these expenses. Additionally, pre TCJA taxpayers could choose to expense costs incurred under either Section 162 as an ordinary and necessary business expenses or under Section 174 as a research expense without major tax scrutiny. With this modification, taxpayers will need to pay close attention to the characterization of the expenses between the two code sections. For costs that cannot be included for the R&D tax credit under Section 41, they should be reviewed to determine if expensing would be more appropriate under Section 162, which would allow an immediate benefit. Tax planning moving forward Many other planning issues will need to be reviewed if this TCJA modification remains, including: For companies that have not taken the R&D tax credit due to net operating losses, these taxpayers must now determine whether their costs incurred should be amortized instead of expensed.Taxpayers may want to evaluate the location of future R&D activities. The longer amortization period for foreign research or experimental expenditures may encourage taxpayers to move additional R&D activities into the United States. Assuming no further changes to Sec. 199A, owners of pass-through entities claim a 20% deduction of qualified business income for tax years 2018-2025. The amortization of research or experimental expenditures may increase qualified business income and thus increase the Sec. 199A deduction. Taxpayers need to act now While taxpayers are focused on current tax filings, they need to keep in mind changes to research or experimental expenditures that began for 2022. Though many industry experts are hopeful for legislative changes this year, there is no guarantee. Taxpayers should analyze these issues now. Do not hesitate to contact any member of our KLR service team for assistance.
