In the final days of 2022, businesses had hoped changes would be made to Section 174 rules requiring capitalization and amortization of research and experimental expenses, also commonly referred to as R&D expenses. Yet, the final bills passed by Congress late in the year excluded this tax provision – making capitalization of qualified expenses applicable for the 2022 year.

Background

Prior to the Tax Cuts and Jobs Act (TCJA), businesses had two options under Section 174 for deducting R&D expenses. Qualified expenses could be immediately written-off, or be capitalized and amortized over five years.

Under the new TCJA provision, taxpayers can no longer immediately expense qualified R&D expenditures, including all direct, indirect, overhead and software development costs. Taxpayers are now required to capitalize and amortize these costs over five years for research conducted within the United States or 15 years for research conducted abroad. It is important to note that amortization is a mid-year conversion. These changes apply to all R&D related costs, regardless of whether the R&D credit is claimed.

With Congress unsuccessful in delaying the Jan. 1, 2022, effective date or repealing the provision, that means changes from the 2017 tax law are now applicable.

Impacts of R&D Capitalization Rule

As a result of the changes, companies need to be prepared to potentially see significant changes in their balance sheets and tax liabilities for the 2022 year, and well beyond.

For example, suppose in 2021 a company reported $10 million in revenue and spent $1 million of deductible R&D expenses domestically. Historically, this company would have reported a taxable income of $9 million – resulting in $2,664,000 federal tax liability.

Starting in 2022, this same company would report a taxable income of $9.9 million after applying the new capitalization and amortization rule for R&D expenses. The remaining 2022 capitalized expenses would be deductible over the next four and half years.

The Simple Math

For companies who regularly incur R&D costs each year, over time the total amount of amortization allowed would provide a larger deduction due to the cumulative effect. However, in the other years it could cause unexpected cash-flow issues related to higher tax payments.

Start Preparing Now

While there is still hope for a retroactive change, taxpayers should be prepared in case a change doesn’t happen before March 15, 2023, which is the traditional filing deadline where these changes will debut on tax returns.

Typically, the Internal Revenue Services (IRS) would require businesses to file a Form 3115 to request a change in accounting methods. However, based on updated guidance set for in Revenue Procedure 2023-11 businesses will only be required to attach a footnote to the tax return for the new accounting method changes for R&D expenses.

Taxpayers should review their current Section 174 activities and costs to ensure proper capitalization of all R&D costs. Contact Doeren Mayhew’s CPAs and tax advisors to help you properly put your R&D expenses on the books, and review your business’s unique situation to deploy other accounting and tax planning methods to reduce any negative impact to your bottom line.