As the books close on the 2022 tax year, a consequential new limitation has gone into effect for businesses hoping to deduct research and experimental (R&E) expenses in the United States.
Under the new capitalization rules for Internal Revenue Code Section 174, businesses can no longer deduct all R&E expenses during the year incurred beginning December 31, 2021, requiring companies to instead amortize and capitalize their annual R&E spend going forward.
The result? For most businesses, significantly higher taxable income in 2022.
What does this look like in practice? Simply put, it’s messy.
First, it’s important to emphasize that these changes to Section 174 represent a separate tax function than the Section 41 R&D tax credit. In fact, with the changes to Section 174 driving up the taxable income at companies of all sizes, Section 41 will become even more important to help reduce the increased tax liability in 2022 for innovative startups and founders.
Historically, Section 174 had a much broader definition of R&E compared to what qualifies as an R&D expense under Section 41, including expenses such as attorney fees and utility costs as eligible funding that could be deducted. (For details on what qualifies for R&D, check out our calculator). Companies often leveraged both Section 174 and Section 41 to help cover costs and extend their runway. This strategy has been viewed as a critical tax function for businesses of all sizes since Section 174 was first enacted back in 1954—and a great mechanism to fuel innovation stateside.
The December 2017 Tax Cuts and Jobs Act (TCJA), however, broadened the scope for what would qualify as R&E beginning in 2022, but significantly tightened how much companies can use R&E deductions to offset expenses. While the impacts are manifold, the most immediate result for many businesses will be the creation of taxable income—even for some companies that haven’t recorded taxable income previously.
The revisions also outline separate requirements for R&E amortization (again, opposed to being used as a deduction for the year accrued) based on geography. For domestic R&E expenses, the amortization period is 5 years, while foreign R&E investments must amortize over 15 years. Going a step further, expenses are “placed in service” at the midpoint of the first year of amortization, making year-one deductions only roughly half of what they could be in following years.
Another kicker for innovative startups? The TCJA went ahead and redefined how software development costs are treated, mandating that any costs paid or incurred with software development—whether for internal or external use—must be treated as an R&E expense, and thus capitalized starting in 2022.
The big question: Why?
Despite pressure from business owners, tax practitioners and even wide swaths of the U.S. Congress, these new amendments to Section 174 plowed right ahead into calendar year 2022 without modification. It’s especially vexing for many stakeholders involved because most view it as an actively un-business-friendly position for the U.S. to take in the face of increased global competition.
The TCJA of 2017 was passed during a highly contentious and partisan period for U.S. lawmakers, as Republicans in all houses were pushing hard to cut taxes on wealthy corporations and individuals. The bill was rife with compromises and a lot of language that frankly wasn’t expected to ever go into effect, especially as election cycles shifted priorities within the House and Senate in the roughly 5 years since the TCJA was put into law.
Without delving too deeply into political waters, what happened over the following years was a waiting game for many businesses and tax practitioners who had been lobbying for lawmakers to pause or repeal changes to Section 174. However, those repeals never came, and while lawmakers may still be able to retroactively allow businesses to leverage R&E deductions for tax year 2022, tax preparers will need to ensure they file according to the latest IRC language as March and April deadlines approach.
What will this mean for your immediate tax filing?
Unfortunately, this is a new frontier for many taxpayers, as a lot of businesses who leveraged R&E leveraged Section 174 tax deductions pre-TCJA never separately accounted for their Section 174 expenses under the revised capitalization guidance. Taking into account the amortization guidelines above—including the new mid-year convention—the amount that businesses will now owe in 2022 compared to 2021 could be a double-digit percentage increase (at least).
The brightside in this scenario? With many businesses now having to claim taxable income either at higher rates or for the first time, the R&D tax credits offered by Section 41 actually become more important and valuable in offsetting dues than they had in the past. Further, your R&D tax credit study can be a great starting point to identifying your Section 174 expenditures, as all Section 41 expenses are inherently Section 174 expenses as well.
At Boast, we help innovative businesses identify and quantify all available R&D activities and expenses that can qualify for tax credits to not only minimize the impact on their annual tax bills, but extend their runway in the face of a rocky financing landscape.
To learn more about how teams can build an R&D Capital Strategy that bears in mind the new requirements around Section 174, R&D tax credits in general, and how to plan for the year ahead, join our weekly #InnovatorsLive event on LinkedIn every Friday at 12pm ET/9am PT.