For tax years ending December 31, 2021 and prior, companies could deduct their entire research and development (R&D) costs on their tax returns. Beginning in 2022, however, that is no longer the case. The 2017 Tax Cuts and Jobs Act (TCJA) amended the tax treatment of R&D expenditures under Internal Revenue Code Section 174. Now companies are required to capitalize and amortize their R&D costs, including software development costs, over 5 years for domestic expenditures and over 15 years for foreign expenditures.
The result is that many companies that were formerly operating at a loss suddenly may have unexpected — and often significant — tax liabilities. Fortunately, there are three strategies that can be used to minimize this liability.
Three strategies for lowering your tax liability
We recommend that companies in this situation strongly consider doing one or more of the following:
Section 382 study
Sections 382 and 383 of the Internal Revenue Code limit the amount of tax attribute carryovers, including net operating losses (NOLs), general business credits and business interest expenses, that can be utilized if the loss corporation has undergone an ownership change.
Section 382 studies are conducted to determine if and when a change in ownership has occurred for a company that desires to use its NOL carryforwards to offset its current taxable income. Given the changes in the taxable treatment of research and development costs, companies that want to use their NOL carryforwards to offset current taxable income should conduct a study to see if they are eligible.
R&D credit study
Another opportunity to reduce income taxes is by claiming an R&D credit, which offers a dollar-for-dollar offset to a federal income tax liability or, for qualified small businesses with less than $5 million in revenue, to offset payroll taxes. Because different sections of the tax code govern the R&D tax credit and R&D capitalization, the credit is not impacted by the new rules around capitalization.
An R&D credit study combines an analysis of the qualified research expenses with a Section 174 analysis to determine how much credit a company qualifies for, and the amount needed to capitalize. Provided the company has been operating at a loss, the taxpayer may be able to claim R&D credits (and carry them forward) for as long as the business has been operating.
Filing method changes
Finally, there are a number of possible accounting method changes that could help defer income taxes, and reviewing current accounting methods is a smart idea. Perhaps the company has taxable income because inflation and a slow supply chain. This could suggest a change to using a Last-In, First-Out (LIFO) accounting method, for example. The company might also consider income recognition changes that accelerate or defer the recognition of income. An acceleration of the deduction of prepaid expenses or making changes in the methods of accounting for inventory might also be possible. It is appropriate to note that changes to an accounting method can be complex and the timing of the request is important to ensure IRS approval.
Contact Robert (Bob) Houston, Of Counsel, in BPM’s Tax department to discuss changing your filing method to save money.
BPM is here to help
While Section 174 is a blow to companies with large R&D expenditures, there are still ways to lower a tax liability and save money. The strategies mentioned above are complicated, however. We strongly advise working with an experienced advisor to ensure that your company takes advantage of all possible savings and stays abreast of future changes in tax law. Contact BPM to learn more.