Beginning with calendar year 2022, taxpayers who are engaged in research and experimentation (R&E) will see a change in the deductibility of Internal Revenue Code (IRC) Section 174 expenses.
Key Changes to Section 174
The major change to Section 174, resulting from The Tax Cuts and Jobs Act (TCJA) signed on Dec. 22, 2017, is that for tax years beginning after Dec. 31, 2021, taxpayers are required to capitalize and amortize their R&E expenses, rather than having the ability to elect to deduct these types of expenses. Further, the Credit for Increasing Research Activities, or “R&D tax credit” under Section 41, is impacted because, generally, to be considered a qualified research expenditure for the R&D tax credit, an expense must be eligible for Section 174 treatment. The TCJA aligned the definition of “qualifying research” as specified R&E expenditures under section 174. Although there have been many legislative efforts to eliminate this upcoming capitalization requirement, they have so far been unsuccessful.
Prior to this change, taxpayers were either able to elect to deduct those R&E expenditures when paid or incurred under Section 174(a), or they could elect to capitalize and amortize those costs over five years under Section 174(b). Further, they were able to write off expenses if a research project were abandoned. However, under the updated Section 174 rules, taxpayers lose that flexibility and will be required to capitalize and amortize “specified R&E expenditures” over five years and continue to amortize expenses even if a research project is abandoned.
It is important to note, however, that foreign research would be amortized over 15 years. This is a significant timing adjustment that all taxpayers should evaluate.
Impact to Taxpayers Going Forward
Potential IRS Positions and Guidance
The IRS may likely take the position that if an expense could be claimed under § 174, it must be claimed under § 174 and amortized, even if it could also qualify as a § 162 deduction or cost of goods sold (COGS). The IRS may provide more future guidance to police whether §41 Qualified Research Expenses (QREs) were claimed as § 174 deductions and amortized. The IRS may be less likely to contest QREs on § 174 grounds.
Core Research & Development Cost Centers
The changes to Section 174 will impact the timing of deducting R&D expenditures for any taxpayer engaged in R&D. Taxpayers will need to capitalize and amortize costs under Section 174 that are associated with those core R&D cost centers, such as research or development teams who are performing R&D activities; instead, the R&E expenses will be amortized over five years. Further, if the taxpayer previously deducted R&E costs for a project under Section 174(a), an automatic accounting method change will be required.
Non-Core Research & Development Cost Centers
For non-core R&D costs, such as those related to qualifying research activities performed under contract, taxpayers will need to:
- evaluate the impact of capitalizing and amortizing the development costs under Section 174 and claiming the R&D credit, or
- account for the costs under an alternative method and deducting currently, therefore forgoing the credit.
How Companies Should Start Preparing
Taxpayers should start considering whether a change in accounting method may be required if they were previously deducting Section 174 costs. This automatic method change will be applied on a cutoff basis. They also should start evaluating their non-core R&D activities to determine their preferred accounting method as well as evaluate the planning of their R&D expenses to accelerate their spend, as appropriate.
Taxpayers who are interested in reclassifying research expenditures into other accounts should consider the IRS perspective and financial statement auditor approach. The IRS can point out prior year positions where taxpayers applied a broad definition of R&D expenditures. Financial auditors may require increased documentation to support both research and non-research classifications.
For more information on how Section 174 changes will impact your industry, contact your DHG advisor or email@example.com.