Changes to the United States Internal Revenue Code Section 174 (S174) have caused a lot of uncertainty for accountants and startup founders alike, as the new language prohibits businesses from expensing R&D costs starting in 2022.
This marks a major departure from almost 70 years of guidance under the U.S. Generally Accepted Accounting Principles (GAAP), which have traditionally allowed the immediate deduction of R&D expenditures under Accounting Standards Codification 730.
This poses huge problems for startups, who are often operating with minimal runway in their early stages and may be faced with an exorbitantly larger tax bill than in years past.
It’s also a tricky and somewhat opaque new terrain for accountants, because many expected the changes—born from the 2017 Tax Cuts and Jobs Act (TCJA)—to be repealed well before December 31, 2021.
While the ship has sailed on the new amortization and capitalization rules being rolled back prior to the 2022 tax filing deadlines, there is still hope that a bipartisan bill currently being re-pitched in the Senate will allow businesses to retroactively take advantage of these pivotal deductions.
In the meantime, how will the new rules around Section 174 immediately impact businesses in the new year?
Fewer audit protections
For starters, at the close of 2022, the IRS published Revenue Procedure 2023-8 as updated guidance that tax preparers must follow in the wake of the new capitalization rules. While there are a bevy of steps tax filers are wise to follow (including new forms and procedures for FY 2022 specifically), there are “ripple effects” outlined in the guidance that are worth calling out.
For instance, Rev. Proc. 2023-8, Section 3.02(7) states that no audit protection is provided for research and experimental expenditures incurred in taxable years prior to 2022. To that end, going forward (ie. post-2022 tax year), the IRS could change how the taxpayer defines certain costs if they encompass the new definition for R&E expenditures paid or incurred under S174.
Going forward, S174 costs will simply encompass a wider range of expenses than those included in the definition of Qualified Research Expenditures for the purposes of the R&D tax credit (Section 41). As such, accountants will need to be more discerning (and detailed) than ever in preparing their filings to the IRS to defend against increasingly-likely audits in the future.
The most frustrating part of this for all parties involved—taxpayers, businesses and likely even the IRS—is that it’s still unclear exactly which costs should be capitalized going forward.
Additional considerations for tax preparers
While there are many unknowns on how the IRS will ultimately treat filings now that TCJA rules have taken effect—even as tax deadlines fast approach—there are a few additional considerations that tax preparers should bear in mind relative to S174.
- Foreign tax issues (Section 199A deduction): The allocation of R&E costs under Treasury Regulation Section 1.861-17 affects foreign tax credit usage, the foreign-derived intangible income (FDII) deduction, global intangible low-taxed income (GILTI), the base erosion and anti-abuse tax (BEAT), the determination of effectively connected income, and the Section 199A qualified business income deduction.
- The impact that the deferral of deductions for R&E costs will have on these items is of particular importance for startups operating across borders, and may call for specialized expertise to ensure businesses are optimizing their available deductions.
- Abandoned projects: In the past, businesses were allowed to deduct the remaining expenditures for projects that were disposed of or abandoned. Under TCJA, taxpayers now must continue to amortize R&D expenditures over their remaining useful life.
- What’s tricky here is that this rule seems to contradict other provisions in the IRC relating to abandonment costs (ie. IRC Section 165), so it’s important for accountants to “stay tuned” and brace for potential audits when claiming expenditures of this nature.
- R&D tax credits: There are a wealth of federal and state R&D tax credits available to businesses that qualify under IRC Section 41 that can be used to offset some of the new expenses businesses will be forced to capitalize under S174. However, the credit qualification criteria specifies that qualified research expenses must meet the definition of R&E expenditures under IRC Section 174.
- As a result, accountants need to be thorough to understand what actually qualifies, which may actually shine a light on new opportunities for credit benefits in the process.
R&D Tax Credits more critical than ever—and a starting point for understanding S174
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.
To that end, the R&D tax credit study you conduct as part of your claim is a great starting point to identify what costs fall under the Section 174 criteria.
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.
Using our AI-driven platform, Boast seamlessly integrates your business’ financial and payroll data alongside the activity and project tracking systems your product teams use every day. This provides a real-time, automated way for you to identify and quantify all available R&D activities and expenses—including Section 174 expenses—that can take a lot of the guesswork out of the claims process (and can be a critical asset to pass onto your CPA).
To learn more about how teams can build an R&D Capital Strategy that reflects the new realities of the U.S. tax codes, join our weekly #InnovatorsLive event on LinkedIn every Friday at 12pm ET/9am PT.