For tax years beginning before January 1, 2022, taxpayers could deduct research and experimental (R&E) costs in the year they were paid or incurred.
For years beginning after December 31, 2021, however, Internal Revenue Code (IRC) Section 174 requires those taxpayers to capitalize “specified R&E expenditures” (including any amount incurred in connection with the development of any software) and amortize the costs over the five-year period beginning with the midpoint of the tax year in which the expenditures are paid or incurred, essentially allowing the taxpayer to deduct 10% of the R&E expenses in Year 1.
A 15-year period (instead of the five-year) applies in the case of any specified R&E expenditures attributable to foreign research (IRC Section 174(a)(2)(B).
As an example, a calendar-year taxpayer typically pays $1,500,000 of specified R&E expenses in a tax year beginning after December 31, 2021. IRC Section 174 now requires that taxpayer to amortize the amount paid ($1,500,000) over 60 months at $25,000 per month in Year 1. The amortization period begins with the midpoint of the tax year in which the expenses are paid or incurred (July), so the taxpayer’s deduction under for the first year would be $150,000.
This new R&E capitalization requirement has surprised some taxpayers and resulted in a significant increase in their taxable income for 2022. In the example above, the taxpayer would have been allowed to deduct the entire $1,500,000 of R&E expenses in a tax year that begins before 2022, but for any tax year beginning after January 1, 2022, the taxpayer’s taxable income is $1,350,000 higher after capitalizing $1,500,000 of R&E expenses and subtracting $150,000 of amortization expense.
Costs Includible for Section 174 Treatment
A good starting point for determining which costs are required to be capitalized under IRC Section 174 is the “qualified research expenditures” that were used to calculate the R&E credit under IRC Section 41 as a conforming amendment to Code Sec. 41(d)(1)(A), which clarifies that after 2021, qualified research relates to R&E expenditures that are amortizable under IRC Section 174. Costs required to be capitalized under IRC Section 174 are even more broad.
The category “specified research or experimental expenditures” used in IRC Section 174 generally includes all costs incurred in the taxpayer’s trade or business related to the development or improvement of a product that would eliminate uncertainty concerning the development or improvement of a product. This includes both direct and indirect costs of carrying out research or experimentation.
An example in the existing regulations – which have yet to be updated to reflect provisions of the current law – includes the following indirect and overhead costs as IRC Section 174 costs to the extent allocable to the research:
- Salaries
- Utilities (heat, light, power)
- Drawings and models
- Laboratory materials and other supplies related to research
- Depreciation of the building attributable to the project
Other costs also required to be capitalized under IRC Section 174 include:
- 100% of qualified contract research expenses, even though only 65% of these costs are permitted when calculating the R&E credit under IRC Section 41
Other indirect costs that may need to be capitalized under Section 174 include:
- Payroll taxes
- Employee benefits
- Indirect labor
- Rent
- Maintenance
- Insurance
The change from the ability to fully deduct R&E expenses to being required to capitalize is a change in method of accounting for tax purposes.
The capitalization requirement under IRC Section 174 will likely result in businesses allocating more of their operating cash to fund taxes for years beginning after 2021. It will be critical for taxpayers to consult with their advisors to comply with the requirements of IRC Section 174 and to implement other strategies to minimize their tax liabilities.
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