Taxpayers who incur research and experimental (R&E) expenditures on or after tax years beginning January 1, 2022, will see a change in the deductibility of Internal Revenue Code (IRC) Section 174 expenses.
Taxpayers should immediately consider any impact on quarterly estimated tax payments.
Key Changes to Section 174
3 R&D Deductibility Changes for Software Developers
- Software development costs are specifically included in the definition of a Section 174 expenditure within the Tax Cuts and Jobs Act (TCJA).
- R&E expenses are no longer deductible under Revenue Procedure 2000-50.
- R&E expenditures must be capitalized and amortized over five years (or 15 years, if foreign).
Historically, with respect to Section 174 R&E expenditures, taxpayers were able to either: 1) elect to deduct when paid or incurred, under Section 174(a), or 2) elect to capitalize and amortize costs over five years, under Section 174(b), beginning in the first month a benefit from the R&E is realized. Further, taxpayers were able to write off expenses if a research project was abandoned.
The change to Section 174 within The Tax Cuts and Jobs Act (TCJA) PL 115-97 signed on December 22, 2017, is that for tax years beginning on or after January 1, 2022, taxpayers are required to capitalize and amortize R&E expenses, rather than having the ability to elect to deduct these types of expenses. Section 174 costs must be amortized over five years for research performed in the US and 15 years for research performed outside the US, beginning with the midpoint in the year in which the costs were incurred. Further, software development costs were specifically included in the definition of a Section 174 expenditure, and therefore must be capitalized and amortized over five years (or 15 years, if foreign). Finally, if a research project is abandoned or disposed of, the taxpayer cannot recover costs earlier than the end of the required amortization period.
Further, the Credit for Increasing Research Activities, or “R&D tax credit” under Section 41, is impacted because to be considered a qualified research expenditure for the R&D tax credit, an expense must be eligible for Section 174 treatment.
Impact on Taxpayers Going Forward
Potential IRS Positions and Guidance
The Internal Revenue Service (IRS) can take the position that if an expense could be claimed as a Section 174 R&E expenditure, it must be capitalized and amortized as a Section 174 expenditure, even if the expense could also qualify as an otherwise deductible cost (i.e., Section 162 ordinary and necessary or cost of goods sold (COGS)). No new regulations or additional guidance has been published to clarify.
Evaluate Location of R&E
Taxpayers should evaluate and model impact of the location where research is performed – within the US or foreign – to maximize the amortization of R&E expenditures.
How Companies Should Start Preparing
Taxpayers should evaluate the tracking of direct and indirect R&E incurred costs, including identification of the location where research is performed to model impact.
Timing of Implementation
Taxpayers will generally be required to comply with these changes no later than the filing of their 2022 tax return. However, taxpayers should consider implementing processes to track R&E costs as they are incurred in 2022. Taxpayers must also quantify the impact of capitalizing R&E expenditures when evaluating quarterly estimated tax payments. If a taxpayer has a short 2022 tax year due to a change in ownership, then compliance would be required at the due date of the short year tax return.
FORVIS can assist you with analyzing the impact of these new requirements as well as optimizing your cash flows related to making estimated tax payments. For more information on how Section 174 changes will impact your Company and to discuss how FORVIS can help with modeling the impact of Section 174, please contact your FORVIS advisor or contact us below.