Change is Here for Research and Development Expenses!

December 22, 2022 Mallory Taylor, CPA, Tax Partner

2017 tax cut and jobs act

The 2017 Tax Cut and Jobs Act rolled back the current deduction allowed to businesses for expenses related to research and experimentation (“R&E”), and 2022 is the first year the change becomes effective. Despite high hopes that Congress would “fix” the rollback, it appears that taxpayers will need to apply the new rules and capitalize these R&E costs for tax purposes, unless a retroactive change is made. This article explains the details of the new law.

Code Section 174 previously allowed for the immediate deduction of expenditures incurred by businesses in the research and development of new products, technologies, and processes. However, in 2017, the law was amended and, starting in 2022, these expenditures must now be capitalized and amortized over a 5-year period (15 years if the R&E activity is conducted in a foreign country). Businesses will now be required to identify and capitalize costs attributable to their R&E activities and allocate them accordingly under a reasonable methodology.

Companies that receive tax credits under Section 41 for their R&E activities are already familiar with these costs, though Section 174 is even broader in scope. The costs that must be capitalized are more expansive than merely the expenses which may be eligible under Section 41 for a research and development tax credit. Regulations for Section 174 explain that qualifying R&E expenditures include all costs incident to the development or improvement of a product, including any costs in eliminating any uncertainties in the development or improvement of that product. In addition to wages and benefits, supplies, and contracted research, the capitalization would also include utilities, depreciation, attorneys’ and other professionals’ fees, and costs for any internally developed software costs. Companies and their tax preparers will have to apply a reasonable allocation methodology for applicable indirect costs.

Certain costs are excluded by statute. They include ordinary testing and inspection costs for quality control purposes, efficiency surveys, management studies, customer surveys, advertising or promotions, the acquisition of a patent, model, production, or process, and research in connection with literary, historical, or similar projects. The statute also excludes exploration costs related to ascertaining the existence, location, extent, or quality of oil and gas and other mineral deposits.

The capitalized costs are amortized on a monthly straight-line basis over a 5- or 15-year period starting at the midpoint of the tax year in which the costs are incurred, regardless of the date when the costs were incurred. If the costs are disposed of, retired, or abandoned during the applicable amortization year, the taxpayer must continue the amortization for the entire applicable period and may not write off the remaining costs.

For financial accounting purposes, such costs will continue to be expensed as before which will cause a book / tax difference and require tracking for tax purposes. The change in accounting for tax purposes will be deemed as an automatic change starting in 2022 and, although filing a Form 3115 will not be necessary, the taxpayer will need to disclose the change in a statement attached to the 2022 business tax return. The change is made on a cut-off basis at the beginning of 2022, and no cumulative adjustment (Section 481 adjustment) is necessary.

Despite bipartisan support to suspend or eliminate the law change, Congress has not included any such revision in its year-end legislation. As December 31 approaches, hopes that a fix will be made available for 2022 appear to be diminishing, although precedent exists for the opportunity to see a retroactive change occurring during 2023.

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