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Limited Deductibility of Research and Experimental and Software Development Costs

By Alexander Cote .

Barring any further legislation, calendar year taxpayers will not be allowed to fully deduct research and experimental (R&E) costs or software development costs when filing 2022 income tax returns. After the Tax Cuts and Jobs Act (TCJA) was passed in 2017, it was quickly recognized as distinct tax reform amongst business owners and tax professionals alike. The TCJA became known for lowering corporate tax rates, the Qualified Business Income Deduction [Sec. 199A], the Limitation on Business Interest Expense [Sec. 163(j)], and the Limitation on Passthrough Business Losses [Sec. 461(l)]. Many of these well-known provisions from the TCJA went into effect for tax years beginning after December 31, 2017.

Major legislation, like the TCJA, typically comes with budget requirements which must be met in order to draw enough votes to pass. To satisfy budget requirements, sometimes more discreet provisions are included with delayed effective dates, with the hope that later legislation will further delay or repeal the provision. One of these more discreet provisions from the TCJA amends Sec. 174 such that it eliminates the ability of taxpayers to immediately deduct R&E expenditures effective for all tax years beginning after December 31, 2021. This amendment to Sec. 174 requires taxpayers to capitalize, not deduct, these costs and amortize them over a period of five years for domestic research and 15 years for research conducted outside of the United States. For taxpayers with domestic Sec. 174 expenditures, this results in 90% of the tax deduction for costs incurred during 2022, now being deferred to later years.

Prior to the TCJA amendment, Sec. 174 provided flexibility for the treatment of R&E expenditures. This included the ability for taxpayers to deduct these costs in the year incurred or treat them as deferred expenses, subject to amortization over a period of no less than 60 months. An annual election under Section 59(e) was also available for taxpayers to amortize research expenditures over 10 years. For tax years beginning before January 1, 2022, Rev. Proc. 2000-50 provides similar flexibility for tax deductions attributable to software development costs. Rev. Proc. 2000-50 allows for software development costs to be deducted in the year they were paid or incurred, or amortized over 60 months. Software development costs could also be amortized under Sec. 167(f)(1) over a period of 36 months, eligible for Sec. 168(k) bonus depreciation.

The revision to Sec. 174 also broadens the scope of applicable expenses to capture the costs incurred related to software development as R&E expenditures. Sec. 174 costs include various direct and indirect costs that are paid or incurred in connection with the regular course of business, with the intent to discover information or eliminate uncertainty regarding the development or improvement of a ‘product.’ Examples of products include a pilot model, formula, invention, process, technique, and software. Common direct costs are labor (including employee benefits), supplies, laboratory costs, third party costs to undertake research or experimentation activities on the taxpayer’s behalf, and cost of obtaining a patent. Section 174 R&E expenditures also include indirect costs allocable to the research project, such as rent and utilities, and depreciation attributable to the research project.

Another modification made to Sec. 174 within the TCJA amendment impacts the tax treatment upon abandonment, disposition, or retirement of a qualifying research project. Also effective for 2022, Sec. 174(d) will require taxpayers to continue the amortization of capitalized costs attributable to abandoned research projects over the remainder of the amortization period. This ensures that unsuccessful projects are not written-off and deductions are not accelerated.

In addition to amending Sec. 174, the TCJA also revised Sec. 41, the research credit. Under Sec. 41(d), for purposes of the research credit, the definition of qualified research indicates expenditures qualify to the extent which they are treated as Sec. 174 specified research or experimental expenditures. In order to claim credit for any expenditures, those costs need be capitalized, not deducted, in the year incurred.

Currently, there is bipartisan support of a taxpayer favorable change to Sec. 174. The House-passed Build Back Better Act from 2021 included a delayed effective date to the Sec. 174 expenditure capitalization and amortization requirement, before stalling in the Senate. Regardless of whether there is further delay or amendment to the new Sec. 174 requirements, further guidance is needed from the IRS and Treasury. Even the AICPA Tax Executive Committee issued comments to the Associate Chief Counsel of the IRS requesting guidance on various Sec. 174 items, including a request to identify what costs are included under Sec. 174.

As 2022 progresses, taxpayers should prepare for this change that is currently in effect. Enhanced reporting or expense tracking may be required to ensure all expenses are classified appropriately. All business owners who conduct research or experimental activities should discuss these newly enacted provisions with their tax professional. It is important to understand that the reduced deductions from these new rules will lead to increased tax liability resulting in potential cash flow restrictions. When calculating quarterly estimated tax payments, taxpayers should work with their tax professional to determine if they should be making increased payments to cover any additional liability. Until further guidance is released by the IRS relating to the full breadth of expenses this covers, comparable analysis should be completed to determine the best course of action.

How Citrin Cooperman Can Help

Citrin Cooperman is ready to help you navigate new tax deductions for 2022. To learn more about R&E costs or software development costs when filing 2022 income tax returns, contact one of Citrin Cooperman’s Manufacturing and Distribution Practice’s tax professionals.

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