Steps to Consider for Changes to Treatment of R&D Expenditures
The passage of the Tax Cuts and Jobs Act (TCJA) on December 22, 2017, represented the largest overhaul of the Internal Revenue Code (IRC) since the revisions made in the Tax Reform Act of 1986. One important provision that has seen significant changes includes the treatment of Research and Development (R&D) Expenditures under Section 174, with the effective date of these changes occurring in tax years beginning after December 31, 2021.
The Build Back Better (BBB) Act under President Biden was meant to delay the cost capitalization requirements of R&D expenditures, but lawmakers failed to sign the Act into law before the effective date of January 1, 2022.
Background of Section 174
Section 174 expenses are costs that are incurred in connection to a taxpayer’s trade or business that represent research and development costs in the experimental or laboratory sense (Treas. Reg. Sec. 1.174-2(a)(1)). Costs qualify as experimental if they are for activities intended to discover information that would eliminate uncertainty pertaining to the development or improvement of a business component, which refers to any product, process, formula, invention, technique, patent, or similar property, and includes products to be used by the taxpayer in its trade or business as well as products to be held for sale, lease, or license (Treas. Reg. Sec. 1.174-2(a)(1) and (3)).
Since 1954, and prior to the effective date of changes under the TCJA, taxpayers were able to immediately expense R&D costs under Section 174(a) or had the option to capitalize and amortize R&D expenditures over a 5-year recovery period under Section 174(b).
Under Rev. Proc. 2000-50, taxpayers were allowed to treat software development costs in a manner similar to the treatments permitted under Section 174, which allowed for an immediate deduction in the year of spend, amortization over a 5-year period from the completion date of the software’s development, or, in accordance with the rules provided in Section 167(f), amortization over a 36-month period from the date the software is placed into service.
Changes Made to Section 174
The TCJA rules updated the terminology of Section 174 costs to “Specified R&D expenditures” to also include all software development activities (Sec. 174(c)(3)), which effectively eliminates the taxpayers’ previously available options to immediately expense or amortize the software development costs over a 36-month recovery period.
As such, the rules for software development, and all other specified R&D expenditures, must undergo a 5-year amortization period for domestic spend, and a 15-year amortization period for foreign spend.
The taxpayer must also now apply the straight-line method and half-year convention in amortizing Section 174 costs. For example, if the taxpayer incurs domestic R&D expenditures of $10,000 in calendar year 2022, the half-year convention requires that the taxpayer treat the mid-point of 2022 as the designated starting point of amortization for the $10,000 total. Since the $10,000 is also amortized over the straight-line method, the taxpayer would deduct $1,000 (half of 20% of $10,000) to represent the second half of 2022 (Year 1), $2,000 (20% of $10,000) for years 2023 through 2026 (Years 2 – 5), and $1,000 again to represent the first half of the final cost recovery year 2027 (Year 6).
Example amortization schedule – Domestic
Year 1, 2022 – $1,000
Year 2, 2023 – $2,000
Year 3, 2024 – $2,000
Year 4, 2025 – $2,000
Year 5, 2026 – $2,000
Year 6, 2027 – $1,000
Please note that although electing bonus depreciation is available to taxpayers that depreciate assets under Section 168(k), bonus is not available for expenditures being amortized under Section 174, despite having a recovery period of 20 years or less.
The amended Section 174 also requires continued amortization of costs in the case of retired, abandoned, or disposed property for which specified R&D expenditures are paid or incurred, and does not allow immediate expensing of costs related to assets that were retired, abandoned, or disposed.
Impact on the R&D Credit under Section 41 and 280C
Section 41(d) originally defined “qualified research” as research with respect to which expenditures may be treated as expenses under Section 174 and was modified to include “specified research or experimental expenditures” under Section 174 as part of the definition for R&D credit purposes resulting from the TCJA updates.
Section 280C(c)(1) was also updated to state that if the amount of credit determined for the taxable year under Section 41(a)(1) exceeds the amount allowable as a deduction for such taxable year for qualified or basic research expenses, the amount chargeable to the capital account for the taxable year for such expenses shall be reduced by the amount of such excess. The Section 280C election to reduce the R&D credit, to the excess of the credit amount minus such credit amount multiplied by the highest tax rate, is only available if the gross credit exceeds the allowable Section 174 deduction for the current year.
These updates to Section 280C(c)(1) may encourage taxpayers to elect the gross R&D credit instead of electing the reduced credit under Section 280C, as the gross credit option will generally yield a more favorable result.
In general, for taxable years beginning on or after January 1, 2015, California law conforms to the IRC as of January 1, 2015. California has not conformed to the federal changes made to the IRC by the Tax Cuts and Jobs Act (Public Law 115-97, enacted on December 22, 2017). In the context of IRC 174, California allows taxpayers to immediately expense R&D costs or capitalize and amortize R&D expenditures over a 5-year recovery period.
Next Steps to Consider
Extra attention must be paid to the distinction between Section 174 and Section 162 expenses, and how they categorize specific costs, as taxpayers are still permitted to treat Section 162 costs as fully deductible in the year incurred, which extends to the treatment of software-related expenditures, and whether the software related expenditures must be categorized as self-developed software, acquired software, and leased or licensed software.
Taxpayers will also want to confirm the location of costs incurred related to R&D expenditures, given the large differences in allowable deductions based on the 5-year and 15-year requirements for domestic and foreign R&D spend, respectively. This may encourage more accurate tracking of locations where Section 174 costs are incurred for the consumption of supplies and raw materials and costs incurred to third-party vendors.
Taxpayers may need to be prepared to perform quarterly tax provision estimates for 2022 that perhaps considers multiple scenarios, by modeling a comparison between having to capitalize and amortize domestic and foreign Section 174 costs, against a scenario where taxpayers can continue to deduct Section 174 expenses based on the eventual likely passage of the BBB in delaying the amortization requirements of Section 174 to tax years starting January 1, 2026.
Anticipated Steps for Congress
Expectation remains that Congress will act to further delay, or altogether eliminate, the need to capitalize Section 174 costs, but it is not clear when the expected “fix” will happen.
Given the similarities to the timing of the technical corrections made to the initial “glitch” regarding the treatment of Qualified Improvement Property’s recovery period and lack of bonus treatment, we cannot expect a timely resolution of this issue with full confidence. The QIP fix was eventually included as part of the CARES Act, an entirely separate piece of legislation, brought on by the COVID pandemic. We must continue to carefully monitor for any updates to Section 174 and the BBB Act, but we cannot assume any timely revisions. With that being said, the issue has House Ways and Means Chairman Richard Neal’s full attention.
Neal says he believes Congress will “renew a series of expired tax benefits this year, including a deduction for research and development costs worth about $30 billion a year to corporations,” reports Bloomberg Law News (2022).
BPM has resources to help navigate these rule changes for planning purposes, which includes any required modeling activities, navigation of congressional updates and law changes, and consulting services related to allocating costs between the appropriate Section 162 or Section 174 categories for the accurate treatments regarding immediate expensing or capitalization and amortization.