Tax treatment of research and development expenses has changed for 2022 and beyond, and not for the better. Previously, R&D investment provided an opportunity for taxpayers to receive favorable tax treatment. Now, amendments included in the Tax Cuts and Jobs Act (“TJCA”) signed by President Trump in 2017 have gone into effect, and the result is the potential for higher taxes on companies that invest heavily in R&D.
The tax treatment of R&D expenses is controlled by section 174 of the Internal Revenue Code—in tax parlance, R&D costs that fall under the purview of section 174 are referred to simply as “section 174 expenses.” The most technical part of understanding how changes to tax treatment of R&D expenses will affect the bottom line is simply understanding the definition of section 174 expenses. If a given cost qualifies as a section 174 expense, its tax treatment will be determined by the new rules; if a cost does not qualify as a section 174 expense, it may be treated as any other ordinary and necessary business expense.
For many taxpayers, section 174 expenses begin and end with the Research and Development Credit—they claim a credit for all their R&D expenses and call it a day. The news rules provided in the TCJA don’t change the applicability of the Research and Development Credit. However, this position has led to a common misconception that if an R&D cost is not included in their credit computation, that cost is not covered by section 174. While all costs included in a Research and Development Credit are section 174 expenses, not all section 174 expenses are included in such a credit. This distinction is important given the changes to tax treatment of section 174 expenses: failure to account for all of one’s section 174 expenses on one’s tax return would likely result in an understatement of income, an underpayment of tax, and potential penalties.
To qualify as a section 174 expense, a particular cost must be 1) incurred as part of the taxpayer’s trade or business, and 2) incurred for the purpose of R&D “in the laboratory or experimental sense.” The second part of that definition is likely to raise some immediate questions. Helpfully, the IRS has issued regulations that specifically define “laboratory or experimental sense.” At a base level, R&D costs are incurred in the laboratory or experimental sense if they are undertaken to gather information about the capability or method for developing a product or the appropriate design of the product. Patent costs—including related attorney fees—are also included in the definition. On the other hand, expenses for activities like consumer surveys, quality control testing, management studies, advertising, and the like do not qualify as section 174 expenses.
In prior years, section 174 allowed taxpayers to treat their section 174 expenses in one of two ways. Either they could defer deducting the expenses and instead amortize them over a period of years, or they could elect to deduct them as ordinary and necessary business expenses as they are incurred. Taxpayers benefited from this election because it maximized their deductions in the year the costs were incurred. For example, if a company invested $100,000 in section 174 expenses, that company could deduct all $100,000 straight away—and substantially reduce their tax burden. In this way, section 174 incentivized R&D expenditure by ensuring qualifying expenses could be fully deducted, the section guaranteed the maximum possible tax benefit short of an outright credit.
That treatment has changed as of January 1, 2022. Per the amendments contained in the TCJA, section 174 no longer allows taxpayers to elect to deduct their section 174 expenses up front. Instead, taxpayers are required to capitalize their section 174 expenses and amortize them over the course of five years in the case of domestic R&D or 15 years in the case of foreign R&D. While the new treatment will produce some new assets on the company balance sheet, the result is a substantially smaller tax benefit for R&D expenses. Returning to the company from the example above, rather than deduct their $100,000 in full this year, they would instead capitalize that expense and deduct a much lower amount over the 5-year amortization period. If that $100,000 were spent on foreign R&D, the treatment is even less charitable and would be required to be amortized over a 15-year period. At even modest rates of inflation, the effects of delaying the full value of the deduction become even more pronounced.
The effect of the new treatment of section 174 expenses, while burdensome, may be mitigated by careful accounting. Only those costs falling within the definition of section 174 expenses must be amortized. Accordingly, costs that can reasonably be construed as non-section 174 expenses may still qualify as ordinary and necessary business expenses, fully deductible all up front. In any event, careful planning is critical to balance the amortization of section 174 expenses, the deduction of ordinary business expenses, and any claimed Research and Development Credit.
It is also worth noting that it has been widely speculated that there is bi-partisan support in Congress to delay the implementation of the requirement to capitalize 174 expenses or completely remove the requirement. If such an action is taken by Congress, it likely will not occur until late 2022 to be applies retroactively.
member center
