Many companies are experiencing unfavorable cash tax payments when filing their 2022 federal income tax returns this fall, as federal law no longer allows an immediate deduction for Section 174 Research and Experimental (“R&E”) expenses incurred for taxable years beginning after 2021. The inability of Congress to pass a tax extender in December of 2022 forces businesses to capitalize and amortize their Section 174 R&E expenses over a 5-year period (15 year-period if attributable to foreign research) beginning with the midpoint of the 2022 taxable year.
Five Tips To Help With 2022 Filing
- Focus on uncertainty.Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.It is important for businesses to delineate between expenditures to eliminate uncertainty versus the general maintenance, customer service, or repairs of products.
- Qualified research expenses utilized for the research credit are only the starting point. While many businesses would like to limit their 174 R&E capitalization to the same expenditures utilized for the research credit, Section 174 R&E expenditures include direct and indirect expenditures.An R&E expenditure for 174 includes all such costs incident to developing or improving a product.For example, labor costs would not only include the costs of full-time, part-time, contract employees and independent contractors who perform, supervise, or directly support R&E activities but also include stock-based compensation, overtime pay, vacation pay, holiday pay, sick leave pay, payroll taxes, pension costs, and employee benefits, related to those same employees.
Another significant difference between expenditures for the research credit versus Section 174 R&E expenditures surrounds contract wages. For purposes of the R&D credit, only 65% of contract wages are included, while 100% of contract wages must be included in Section 174 capitalization.
Lastly, unlike the research credit, Section 174 R&E expenditures include costs incurred for creating a pilot model and obtaining a patent. Examples of patent costs include attorneys' fees expended in making and perfecting a patent application.The term pilot model means any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product. - Form 3115 is not required for the change in method of accounting related to Section 174 R&E expenditures if the change was made in the taxpayers’ first taxable year beginning after December 31, 2021. The IRS issued Revenue Procedure 2023-8, allowing taxpayers to obtain automatic consent to change the accounting method for specified research or experimental expenditures to comply with IRC Section 174 by attaching the required information in a tax return statement. The statement describes the method change and discloses the capitalized expenses for tax purposes.
- A Section 280C election is probably not advantageous for taxpayers capitalizing R&E expenditures and claiming a federal research credit. Under the new law, the requirement to add back the qualified research expenditures when determining taxable income or make an election under 280C to reduce the research credit by the tax-effective amount of the qualified research expenditures is no longer required. If the 280C election is made, a taxpayer could be reducing their research credit for no reason and severely impacting federal cash tax payments.
In general, if the 280C election is not made and the research credit is less than the allowable 174 deductions, then no adjustment is made to the research credit or the 174 R&E amortizable deduction. If a 280C election is not made and the research credit is greater than the allowable 174 R&E deduction, then the 174 R&E asset going forward is adjusted for such excess (but the current year’s expenses are not adjusted). - While many taxpayers hope this law will be repealed, there are still lengthy negotiations that must take place in Congress before a repeal of 174 R&E becomes a reality.While the House Ways and Means Committee has introduced the Build It In America Act that would delay the capitalization of 174 expenditures until taxable years being after December 31, 2025, the partisan politics could get in the way of such a bill passing. Businesses and accounting firms will monitor the progression of the bill closely, however, 2023 estimated tax payments should still include the capitalization of 174 R&E.
Authors: Lynn Mucenski-Keck, Principal and National Lead, Federal Tax Policy |[email protected] and Lore Bilbao, CPA, MAcc |[email protected]
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