Since 1954, companies engaged in research and development (R&D) activities have been able to fully deduct their R&D expenses against their taxable income. This treatment is allowed for qualified research expenses (QREs) related to domestic and foreign research under Internal Revenue Code (IRC) Section 174. QREs include: (1) wages and salaries of applicable research staff, (2) subcontract labor, (3) materials and supplies used in qualified research and (4) the costs of operating and maintaining research facilities (e.g., rent, utilities, insurance, etc.).
Treatment of Equipment and Buildings
Expenditures for equipment and buildings used to perform such research must be capitalized and recovered through claiming the appropriate depreciation allowances. The option has always been available to capitalize the expenses and amortize over time, as is often done on a GAAP basis. However, an immediate tax deduction has always been an attractive option and key to cash flow, especially for traditional start-up companies.
Research and Development Accounting Changes Post-TCJA
To paraphrase the poet Geoffrey Chaucer from the mid-fourteenth century: All good things must come to an end. When the Tax Cuts and Jobs Act of 2017 (TCJA) was signed, along with it came many beneficial tax changes for corporations. One benefit was the reduction of the US corporate income tax rate from a maximum of 35-percent to a flat 21-percent. The loss of revenue from this tax rate reduction is being made up in multiple ways, including a change in accounting for R&D. Most changes in the tax reform were to take effect immediately in the 2018 tax year. However, the change to R&D was delayed until January 1, 2022, in order to give companies more time to plan. That day is now almost upon us.
Changes Effective in 2022
Beginning in 2022, companies will be required to capitalize all R&D costs. No exceptions. There will be two options available for amortization. As already previously allowed under IRC Section 59(e), taxpayers may amortize QREs over 10 years, starting with the year when the expenditures were paid or incurred. This method is generally used for long-term manufacturing contracts subject to a percentage of completion methods. Next year, under newly amended IRC Section 174, taxpayers must capitalize the costs over five years for domestic research and 15 years for foreign research beginning with the month they first realize benefits from the expenditures. Unlike R&D credits that specifically exclude R&D work performed abroad, the capitalization and amortization policy does allow for the deduction of R&D services offshore, just at a slower amortization rate.
Current Opposition
The loss of IRC Section 174 R&D expensing has drawn bipartisan opposition. One concern is that this will lead US-based companies to conduct less domestic R&D and move more to offshore locations with lower labor costs. The five-year amortization period might increase the after-tax cost of domestic R&D relative to the after-tax cost of R&D done in other countries. While this concern may be offset by the lengthier 15-year amortization period, the overall analysis may still yield a better ROI on offshore development.
Two separate bills have been introduced to protect the current R&D expensing provisions. The American Innovation and R&D Competitiveness Act of 2021 (H.R. 1304) and the American Innovation and Jobs Act (S. 749) were introduced in February 2021 and sponsored by Rep. John Larson (D-CT). Both bills aimed to eliminate the capitalization requirement as set forth in TCJA. As of August 31, 2021, there has been no movement on either bill.
Software Development
Currently under Rev. Proc. 2000-50, software development costs may either be expensed immediately and deducted in the year paid or incurred or amortized and deducted ratably over a period of at least 60 months from the date of completion of development or over 36 months from the date the software is placed in service. The distinction lies with if the software is internally developed or acquired “off-the-shelf.” Generally acquired software is capitalized and amortized over 36 months beginning with the month the software is placed in service and eligible for bonus depreciation. The cost of leasing or renting software for use in the taxpayer’s trade or business is deductible as an ordinary business expense. Internally developed software has afforded the option of expensing or capitalization.
The TCJA does not specifically address software development, as it relates to the capitalization and expensing under the five- or fifteen-year rules of IRC Section 174; however, general guidance on this topic suggests that it should in fact be considered. Software development generally includes the design, coding and testing of new or improved software, and is treated in the same manner as capitalized R&D costs under these provisions. Costs associated with the purchase or license of off-the-shelf software, requiring little to no customization, software maintenance, training, or business process-related activities and costs are generally excluded from any capitalization treatment. However, it may now be necessary to consider the current year amortization cost of the software within the total R&D expenses to the extent the software is utilized in the R&D function of the organization.
Planning for the Change
With no movement in counter-legislation to reverse the impending change to R&D expensing, it is time for companies to begin proactively preparing for it.
- Acquisition versus Development – Companies may now want to consider acquiring property related to research in lieu of developing it. Acquired assets may be eligible for accelerated or bonus depreciation (100-percent through 2022). Software is a great example of this.
- Books and Records – If not already in place, implement accounting processes to better identify R&D expenditures (as defined under IRC Section 174) and separate them from other deductible production and administration expenses. Be prepared to best break out what must be capitalized and what may still be deductible.
- Cash Taxes – Taxes in future years may go up with less expense to take. The five-year (or 15-year) capitalization period will mean an increased tax liability due to the deferred deductions. Ensure that enough cash is available to cover estimated tax payments.
- Keep Projects Going – Reconsider abandoning R&D projects prior to completion. Previously companies were able to write off the remaining basis of R&D costs when they shut a project down. Now, however, they will be required to continue to amortize an abandoned project over its remaining useful life
- Research Credits – Under the regular R&D tax credit, R&D expenses that are eligible to be amortized after 2021 are reduced by any excess of the research credit allowed for the tax year. Consider electing the reduced R&D credit elect on a timely filed tax return to eliminate this potential additional add back to income.
Accounting Method Change
The TJCA states that this change to R&D capitalization is a change in a method of accounting, even though it is being mandated. The change will be treated as initiated by the taxpayer with the consent of the IRS and implemented on a cutoff basis with no section 481(a) adjustment. The IRS has yet to issue guidance on whether this will be an automatic method change filed on Form 3115.
The Silver Lining
As they say, every cloud has a silver lining, so maybe every tax law change has a potential upside. Corporations and individuals alike have been holding their breath anticipating the impending tax increases that loom in the future. The timing and impact of both remain to be seen, but the general consensus is that they are coming, especially for corporations. The expectation is that the now 21-percent flat corporate tax rate will rise to around 28 percent. When tax rates are expected to increase the typical reaction is to recognize income now and delay expenses. The changes to R&D expensing under IRC Section 174 have forced the hand and will now require businesses to delay that expensing for at least a five-year period. Thus, pushing expense into potentially higher tax years. A $1 million R&D expense today is worth $210,000 in tax savings. Capitalized over five years that could result in a total of $280,000 future tax savings if tax rates do indeed rise.
In addition, companies may now be required to more closely examine their true R&D activities. It has always been very simple to take the “deduct all” approach without really breaking out the technological or innovative aspects of what is categorized as true research and development and what is not. The forced capitalization may cause companies to step back, reevaluate, and potentially identify even more opportunities that qualify for the R&D tax credits. Cash credits outweigh tax deductions every day of the week.
For further questions about R&D activity, please contact Nicole Suk.
