The Tax Cuts and Jobs Act (TCJA) of 2017 brought about a number of changes to the way that research and experimentation (R&E) expenses are treated under Section 174 of the Internal Revenue Code. While many provisions of the TCJA went into effect immediately, changes to Section 174 were only effective after December 31, 2021 – meaning businesses will have to navigate these new changes in the 2022 tax year.
At its core, Section 174 of the Internal Revenue Code (IRC) provides certain tax benefits for companies that incur R&E expenditures incurred in connection with the taxpayer’s trade or business. R&E expenditures generally include all costs incurred in the development or improvement of a product. (26 CFR § 1.174-2).
Prior to the TCJA Amendment to Section 174, taxpayers could deduct the full cost of R&E expenditures in the year they were incurred. Now, however, these costs must be amortized over at least 5 years. Fundamentally, this means that businesses will see an increase in taxable income the first year those expenses are incurred.
Overview of the changes
The TCJA amendment to section 174 requires taxpayers to capitalize and amortize their R&E expenditures from the midpoint of the taxable year in which expenses are incurred. Prior to the TCJA, taxpayers could immediately deduct R&E expenditures or amortize the expenditures over a period of 5 (for domestic expenses) or 15 years (for foreign expenses). Most taxpayers opted to use the immediate deduction, but that option will no longer be available. This change will likely lead to a year one increase in taxable income, but businesses could see increased deductions for subsequent years if they were previously deducting expenses up-front.
For instance, if a business has $1 million in domestic R&E expenses for a calendar year, it must amortize $1 million over five years ($200,000 annually) instead of taking a $1 million deduction in the first year, as was the case in the past. Also, they must amortize the expenses from the midpoint of the year, potentially cutting the first year’s deduction in half. In this case, that means the business can only deduct $100,000 in the first year, instead of the entire $1 million.
Additionally, the research expenses that must be capitalized are broader than those typically associated with R&E costs under section 41 of the IRC. Section 41 of the IRC provides for a tax credit (called the Credit for Increased Research Activity) for certain R&E expenditures, but it only covers a narrow range of R&E costs that are not the same as those defined under Section 174. In a nutshell, costs eligible for the deduction under Section 174 are broader than costs eligible for the credit under section 41.
For example, the Section 41 credit applies to salaries, supplies, and contract research, while the Section 174 deduction can include expenses for things like utilities, depreciation, attorneys’ fees, and other costs incident to the development or improvement of a product.
This difference between eligible expenses means taxpayers will have to partition and calculate Section 174 expenditures separately from expenditures eligible for the Section 41 credit as the Section 174 expenditures will need to be amortized.
What these changes mean for businesses and their accountants
As a result of the Section 174 changes, some taxpayers may have to file an Application for Change in Accounting Method (Form 3115) if they were not previously amortizing their R&E expenses. Businesses also need to ensure all R&E expenditures are properly identified as a result of these new guidelines.
For those companies who were already capitalizing and amortizing their R&E expenditures, the Section 174 changes will be minimal – but it stands to dramatically affect businesses who were deducting the full cost of R&E expenses in the year incurred.
Contact our office for assistance
While this article provides an overview of changes to the Internal Revenue Code, it is not a substitute for speaking with an expert advisor. If you’d like to learn more about R&E deductions or credits, contact our office and we’ll discuss your unique situation.