Research and Development Expenditures: Change Is Coming
For many years, taxpayers have enjoyed favorable treatment and flexibility for research and development (R&D) expenditures. Under Section 174, the tax section governing R&D expenses, taxpayers have had the option to deduct their expenses in the period in which they were paid or incurred, or to capitalize and amortize the deduction.
The Tax Cuts and Jobs Act (TCJA) included a provision requiring research and development (including software development) expenditures to be capitalized for tax years beginning after Dec. 31, 2021. Many industry experts expected a repeal or a delay of the effective date of this provision. However, despite numerous attempts to change the law, including the most recent version of the Build Back Better Act, the TCJA’s rule is still in effect. While it is still possible for Congress to address and retroactively change this rule, it is important for taxpayers to begin planning to comply with the law as it currently stands.
What Does It Mean for Me?
For tax years beginning after Dec. 31, 2021, taxpayers will be required to capitalize R&D expenses incurred in the United States over five years and foreign expenditures over 15 years. As taxpayers begin to assess the impact and the increase to taxable income, there are several things to consider:
- Increased administrative tracking: The expenses required to be capitalized as R&D are broader than what would qualify toward the R&D credit itself. There almost always will be additional costs subject to capitalization that will not qualify for the R&D credit. Taxpayers will need to carefully analyze and consider these other costs. In addition to assessing the potential impact to taxable income and estimated payments, it’s also important to consider how you can identify and track these additional costs.
- Applicable to all taxpayers: If you are thinking, “I don’t have an R&D credit so I must be okay,” you might be mistaken. Consider the following.
- The law applies to all taxpayers regardless of whether you are claiming the credit or not. Perhaps your business is still in the early stages and not producing taxable income, so you haven’t given the credit much thought. You are still required to comply with these provisions. With any tax decision, there are practical considerations, but it’s important to recognize there is no materiality threshold for capitalization.
- What qualifies as R&D for tax purposes is broad and includes many types of activities you might not consider as research and development. While many think of R&D as white lab coats, test tubes and beakers, artificial intelligence, etc., the tax definition is actually much broader and includes things like software development, manufacturing engineering, product development, engineering/design, and more. After evaluating the rules, it’s quite possible that some taxpayers will not only realize that they have R&D expenses subject to capitalization, but also that they may be eligible for the R&D credit.
- International Operations: Mandatory capitalization also applies to foreign controlled corporations and may impact FDII and/or GILTI calculations. Understanding the changes to these calculations and the impact to your overall tax position will require special attention.
Assessing Your Options
KSM’s professionals can help assess the impact of mandatory capitalization and address your immediate concerns, such as how this might impact estimated payments. We can also offer guidance to help you assess the larger impact to your business and what information and documentation will be needed to comply with the new law. Considering and planning early in the year may allow you to modify your systems or processes to gather information in real time and minimize your burden at year-end.
For more information or to discuss your R&D tax credit options, please contact a KSM advisor or complete this form.
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