Research and Development (R&D) has long been an important focus area for many businesses. R&D activities, undertaken to innovate and improve products, processes and services, have driven vast amounts of shareholder value.
Since the 1981 introduction of the R&D Tax Credit, many businesses have enjoyed tax benefits as a result of their investments in R&D activities. These benefits, designed to incentivize scientific and technological advancements, have fueled dramatic innovation across various sectors of the U.S. economy.
For tax years beginning in 2022, certain changes went into effect governing how businesses recognize and report expenses associated with R&D activities. Whereas previously, a business was generally able to deduct R&D expenses fully in the year they were incurred, these expenses must now be capitalized and amortized over longer periods, as specified by Section 174 of the Internal Revenue Code.
The changes were enacted against a backdrop of relative uncertainty. First introduced by the Tax Cuts and Jobs Act in 2017, the changes to Section 174 were not scheduled to go into effect until the 2022 tax year. In the intervening years from 2017 until today, there has been a concerted effort to repeal these changes, but to date, these efforts have been unsuccessful.
For businesses preparing their 2022 tax filings, the revised Section 174 rules apply. These new requirements can apply to many types of businesses: not just those that have historically claimed R&D tax credits. It is now imperative for business leaders to understand the tax impact of these changes, both for 2022 and future tax years. Read on for an overview of the key changes businesses need to be aware of.
Prior to the 2022 tax year, a business’s R&D expenses such as employee salaries, raw supplies, and third-party contractors were generally tax deductible.
Under the new rules that went into effect in the 2022 tax year, many R&D expenses are no longer deductible in the year they are incurred. Instead, businesses are required to capitalize and amortize these expenses over certain periods of time: 5 years for domestic activities and 15 years for foreign activities.
While this requirement to capitalize and amortize R&D expenses was the headline change, there are additional layers of complexity to the regulation that business leaders should also understand. Below is a brief overview of each of the key concepts.
The expenses that Section 174 requires businesses to capitalize and amortize are far broader than the expenses business typically would consider for an R&D tax credit.
Section 174 requires businesses to capitalize and amortize all costs related to the development or improvement of a product or process. This definition includes the direct costs typically associated with an R&D Tax Credit: direct employee wages, supplies, and third-party contractors. But crucially, it also includes a wide range of indirect costs, such as payroll taxes, depreciation on a building where R&D activities take place, patent fees, and other expenses.
In many instances, this requires businesses to determine and proportionally allocate indirect costs toward R&D activities. These costs must then be capitalized and amortized on the appropriate schedule.
Some expenses do remain excluded from these Section 174 regulations. Excluded costs include consumer surveys, management studies, advertising expenses, and others, as specified by the IRS.
Section 174 also requires that businesses capitalize and amortize many of the costs associated with software development, which were previously deductible. For technology businesses, these changes may have a significant impact on tax strategy.
It’s a common misconception that R&D tax credits, and by extension, R&D tax laws, primarily apply to manufacturing or technology businesses. And while it’s true that the majority of federal R&D tax credits are claimed by businesses in these industries, the reality is that other types of businesses can pursue an R&D tax credit: from professional services firms to insurance businesses.
Whether or not a business has pursued an R&D tax credit in the past has no bearing on its requirement to be compliant with Section 174. Though many businesses fail to pursue credits they may be entitled to, this does not preclude them from having to be compliant with Section 174.
It’s vital that businesses consult with their tax advisor to identify and allocate any expenses which fall under Section 174. If a business has or is pursuing R&D tax credits for any of these activities, there must be clear alignment between the accounting processes for both of these matters. Otherwise, businesses run the risk of facing significant penalties if they are found to be non-compliant.
These changes to Section 174 are independent of existing R&D tax credits available under Section 41. For many businesses, R&D tax credits remain an extremely valuable tax strategy. The decision of whether to pursue them should not be affected by changes to Section 174.
Successfully claiming an R&D tax credit delivers a permanent benefit to a business. In many instances, businesses can realize a 6-10% benefit on qualifying R&D expenditures through the federal R&D tax credit. This can be supplemented further by state R&D tax credits, which are available in 34 U.S. states.
Seeking these tax credits results in a lower effective tax rate, increased return on investment, and improved profitability. While these expenses now have to be capitalized over a number of years instead of deducted in the year they are incurred, R&D tax credits still offer a permanent deduction in tax and should be pursued where appropriate.
Related: Tax Credits and Incentives
As with any new tax regulation, it’s important for businesses to proactively discuss the impact of these regulatory changes with an experienced tax advisor. Businesses that already claim R&D tax credits are well aware of the importance of robust processes and documentation, and the same principles apply in ensuring Section 174 compliance.
While IRS guidance on this topic continues to evolve, the team at Smith + Howard is available to ensure that businesses are prepared to meet their obligations. If you’re seeking professional tax advice for your business on R&D Credits, please contact an advisor today.
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