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New Tax Requirement to Capitalize R&D and Software Costs

Taxpayers, including healthcare organizations, must comply with new tax requirements on R&E and software development expenditures. Read more about the impact.
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Healthcare companies often invest heavily in their technology platforms and service delivery models. When these taxpayers invest in software development by paying their employees or outside developers to enhance or customize their software platforms, then new requirements to capitalize software development costs may need to be considered.

Effective for tax years beginning after December 31, 2021, taxpayers are required to capitalize and amortize U.S.-based research and experimental (R&E) expenses over a period of five years and non-U.S. R&E expenses over 15 years. Software development costs are specifically included as R&E expenses under Internal Revenue Code (IRC) Section 174(c)(3) and subject to the same mandatory amortization period of either five or 15 years. This new requirement will impact for-profit companies, including healthcare companies that are making these types of investments. Note that the new capitalization requirement applies regardless of whether a taxpayer is or has previously claimed a Research and Development Credit.

Prior to this change, taxpayers could adopt one of three tax accounting methods: currently deduct these costs under prior IRC Section 174(a), capitalize and amortize these costs over no less than 60 months starting with benefit onset under prior IRC Section 174(b), or make an election under IRC Section 59(e) to amortize R&E expenditures over 10 years. Similarly, for software development costs, taxpayers had the option to expense these costs as incurred, amortize them over 36 months from the date the software was placed into service, or amortize over not less than 60 months from the development completion date.

Impact on Taxpayers Going Forward

Evaluate Location of R&E

Taxpayers should evaluate and model the impact of the location where research is performed—within the U.S. or on foreign soil—to increase the amortization of R&E expenditures.

How Companies Should Start Preparing

Taxpayers should track direct and indirect R&E costs, including identification of where the research is performed. They may then want to model the impact on cash flow, taxable income, and other key tax metrics.

Timing of Implementation

Affected healthcare organizations will generally be required to comply with these changes no later than the filing of their 2022 tax return, which also includes consideration in their 2022 estimated tax payments. The mandatory IRC Section 174 capitalization rules could potentially have a material impact on businesses performing R&E activities. If a business has not begun to plan, model, and evaluate the impact of these new rules on taxable income, cash taxes, estimated tax payments, tax rate, related international provisions, or state tax posture, or develop a process to efficiently capture and allocate these costs, we recommend beginning as soon as possible. Taxpayers need to be prepared to provide documentation to the IRS substantiating the computation of their IRC Section 174 costs. We recommend that taxpayers have a plan in place to identify and track IRC Section 174 expenses going forward.

FORVIS can assist you with analyzing the impact of these new requirements as well as improving cash flows related to making estimated tax payments. For more information on how IRC Section 174 changes will impact your company and to discuss how FORVIS can help with modeling the impact of IRC Section 174, please contact a professional at FORVIS or submit the Contact Us form below.

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