The IRS will require business owners to amortize Section 174 research expenses over multiple years instead of deducting them in the year incurred unless a provision in the Tax Cuts and Jobs Act changes before December 31. Through 2021, businesses could deduct Section 174 expenses in the year in which they were incurred or capitalize and amortize the costs over five years. But this new provision eliminates the former option.
This change could significantly impact your firm’s financial statement and cash flows, especially if you’re involved in technology and life sciences and conduct a lot of research — instead of a tax loss, your firm would have a taxable profit. Costs that you’ve been deducting for research costs may not be deductible next year.
Starting in 2022:
Sec. 174 expenses associated with research conducted in the U.S. will be capitalized and amortized over a five-year period.
Sec. 174 expenses associated with research conducted outside the U.S. will be capitalized and amortized over a 15-year period.
If, for instance, your business spends $100 on domestic research activities in 2021, you can deduct the full $100 of Sec. 174 expenses in that fiscal year. But in 2022, if you again spend $100 on research, you’ll have to deduct it incrementally over a five-year period. This could lead to an unexpected increase in your taxable income, especially in the first few years these rules will apply.
Learn the details
Sec. 174 has always been complex, so now is a good time to look at what is and is not changing.
To start with, you need to understand that Sec. 174 expenses and the R&D tax credit are two distinct concepts. All R&D credit expenses must qualify as Sec. 174 expenses, but not all Sec. 174 deductible expenses need to meet R&D credit requirements. You have Sec. 174 expenses even if you don’t claim R&D tax credits.
The R&D calculation focuses on direct research expenses such as wages paid, supplies purchased and amounts paid to use contractors. Sec. 174 expenses include these costs but also such indirect research expenses as facilities costs and depreciation.
The R&D credit can be taken for increasing research activities beyond a baseline. Sec. 174, under current law, allows costs to be deductible without having to exceed a threshold. This means that sometimes Sec. 174 costs will qualify for R&D credit and sometimes not.
If your business operates in multiple countries, you’ll need to identify not only how much money you spent but also in which location you spent it so you can properly track whether the expenses are subject to the five-year or the 15-year amortization period. Reviewing expenses often will help you identify opportunities to amend recent tax returns to grab unclaimed R&D credits, which is not a bad thing at all.
You should optimize your cash flow tax planning, consider documenting your R&D credits to IRS standards if you haven’t already done so and reconsider your accounting methods for such favorable changes as accelerating deductions or deferring revenue and costs. You can provide cash savings and positively impact your cash flow forecast no matter what happens in 2022.
Finally, keep an eye out for legislative changes. Nothing is certain, but it is possible that legislation may strike down the new rules before year-end.