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This year, several changes went into effect that significantly impact the way that companies treat Research and Experimental (R&E) Expenditures. Although there is pressure on the federal government to delay these changes, as of now they will be applicable for the forthcoming tax season.
Ultimately, these changes make the R&D Tax Credit more valuable to taxpayers who could become taxable sooner than they previously would have been prior to the changes.
Here’s what you need to know.
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Reminder: What are R&E Expenditures?
Under Section 174, R&E expenditures are costs incurred in connection with the taxpayer’s trade or business which represent research costs in the experimental or laboratory sense. The term generally includes all costs connected to the development or improvement of a product, whereas Section 41 for R&D Tax Credit lists specific costs that are qualified research expenses.* A few examples of Section 174 R&E expenditures include:
- Salaries
- Pilot Models
- Patent Costs
- Laboratory Materials
- Attorney’s Fees
- Overhead Costs
*Section 174 (R&E Expenditures) can capture more cost types than R&D Expenses under Section 41 (law for R&D Tax Credit). Only 4 types of expenses are eligible for the R&D Tax Credit (in-house labor, third-party research, computer leasing and supplies)
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What is the new required treatment of the R&E Expenditures?
Beginning in 2022, taxpayers, including startups and small businesses, are required to capitalize and amortize all R&E expenditures over 5 years for domestic research, and 15 years for foreign research (1). Previously, taxpayers had the option to either immediately deduct R&E expenditures incurred in the tax year or capitalize and amortize domestic and/or foreign expenses over time.
In short, this means that companies who were used to deducting large R&E expenditures have to spread out the use of these deductions over a longer period of time, potentially rendering them taxable much sooner than they previously thought.
These new requirements impact the taxpayers starting in all years after 2022. So when you go to prepare your taxes this year, make sure you consider the following points:
- Discuss with your CPA to identify which costs fall under Section 174 R&E Expenditures to meet the new requirement
- Work with your CPA to consider the interplay between Section 174 (R&E Expenditures) and Section 41 (R&D Tax Credit) for optimal tax planning.
- Evaluate the location of future R&D activities that directly affect the capitalization and amortization of R&D expenditures (ie., re-evaluate where your R&D activities currently take place, and decide whether you want to conduct R&D activities globally, or in the US.)
- Be aware of the net operating losses (NOLs) limitation that could also impact the income tax liability, especially if expecting to become taxable after implementing the new Section 174 capitalization requirement.
Don’t worry if this all sounds a little dense – we’ve gathered a few examples to help illustrate how these changes could impact your company’s tax liability below.
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Let’s take a look at some examples
Example 1: Company A with no prior operating losses.
In this first example, we are assessing Company A’s income tax liability before, and after the changes.
Prior to 174 changes
Prior to the 174 changes, Company A incurred $10,000,000 in R&E expenses. This happened to be equal to their total income that year, which means that they had a net income of $0, and a total tax liability of $0.
With the New 174 Changes
However, with the new Section 174 changes, this has drastically changed. While the company earned the same $10,000,000 in income, they are now only able to deduct a small portion of the R&E expenses.
Assume that in this example 70% of expenses are characterized as R&E expenses ($7,000,000), and Net Operating Losses (NOL) are 0. With the new requirement, you can only deduct $700,000 (1/5 * 1/2 of total R&E expenses) in year one whereas before you could have deducted $7,000,000.
Company A also gets to deduct their total expenses for the current year ($3,000,000) that do not include R&E Expenditures.
Deductible R&E expenses in year 1: $700,000
Non R&E expenses: $3,000,000
Total expenses that can be deducted from taxable income: $3,700,000
So, in total, Company A’s total taxable income is $6,300,000 ($10,000,000 – $3,700,000), and they will owe $1,323,000 assuming a tax rate of 21%.
Example 2: Company with Net Operating Losses (losses incurred prior to Tax Year 2021)
In this example, Company B has a similar situation as Company A, except that they also have $8,000,000 in Net Operating Losses (NOL’s) available.
Prior to 174 changes
Company B generated $10,000,000 in total income, and also incurred $10,000,000 in expenses. However they also have $8,000,000 in Total Net Operating Losses (“NOL” carryforwards from prior years, assuming all NOLs were generated in pre-2021 tax years).
If we evaluated this company prior to 174 changes, this company would have a total taxable income after NOLs of $0.
With the 174 changes
With the 174 changes, Company B still incurred $10,000,000 in income and expenses.
The total allowed amortization of current year R&E expenses is still $700,000, so the total expenses allowed as a deduction is $3,700,000.
However, total taxable income is still $0 because you they have a total taxable income of $6,300,000 before NOLs, and they have $8,000,000 NOLs (100% applicable) available to offset taxable income. The remaining $1,700,000 will be used to carry over into the next tax year.
Example #3: Company with Net Operating Losses (incurred post Tax Year 2020)
Prior to 174 changes
Similar to Company A and B, Company C earned $10,000,000 in income and $10,000,000 in expenses. Company C also has $8,000,000 in NOLs generated in the 2021 tax year.
With the new 174 changes
Assuming $7,000,000 of R&E expenses, Company C can only deduct $700,000 of their R&E expenses for the first year (same as Company A and B).
Company C also has $8,000,000 of Net Operating Loss from the previous year. However, because these net operating losses were generated post tax year 2020, Company C is only allowed to offset 80% of the taxable income.
After applying the NOL, Company C will have taxable income of $1,260,000, resulting in total tax liability of $264,600, assuming a tax rate of 21%.
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In Summary: What do I need to do?
These changes may seem overwhelming, but rest assured you will be more than prepared this tax year to take advantage of R&D Tax Credits, whether or not you are now taxable. MainStreet is always here to help, so don’t hesitate to reach out for guidance as the tax season approaches.
Action Item:
- Be aware that new laws have taken effect.
- Coordinate with your CPA to fully understand impact and if you are now taxable.
- Make sure you’re taking advantage of R&D income tax credits even if you have aged out of payroll tax credits.
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Footnotes
1. The rule requires a ½ amortization in the first year. Because the rule requires the company to amortize the expenses over 5 years, they would deduct only $700,000. The capitalization and amortization begins with the midpoint of the taxable year in which such expenditures are paid or incurred (“half-year convention”)
2. Additionally, Rev. Proc. 2000-50 also provided that software development costs could be deducted currently or capitalized and amortized over 5 years.
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