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Tax Cut Job Act Updates: Mandatory Capitalization of R&D Expenditures

By Gregg Wirtschoreck, Ewa Anikiej .

As seen in the Chicago Business Journal


The manufacturing and distribution industry is always challenged to improve their products and maintain efficient operations while staying ahead of the competition. Today’s globalized and competitive economy forces the businesses within the industry to boost technological development at an unprecedented pace.

For many of businesses, the rapid changes in features and functionality requires increased complexity, cost, and risk in research and development activities and expenditures.

Research and development expenditures (R&D), are the costs incurred by a business for its efforts to develop, design, and enhance its products and operations to address these fast-paced changes. Businesses conduct R&D to create or update new products or services or to develop new machinery or processes to improve operations.

Background

Prior to Jan. 1, 2022, most businesses elected, under Internal Revenue Code Section 174, to deduct qualified R&D expenditures in the same year as incurred even though the option to amortize the expenditures over at least five years existed. With respect to any taxable year, the immediate R&D deduction, as opposed to amortizing over at least five years, provided businesses with a benefit of a reduced federal income tax in the same year the business incurred the expense. The option to amortize R&D cost saw a limited use.

To enhance the R&D deduction, many in the industry took advantage of the R&D Tax Credit, which is set forth in Internal Revenue Code Section 41. The R&D Tax Credit is a stated percentage of qualifying R&D expenditures such as domestic wages, domestic contractors, supplies and other costs that are determined to be incurred as part of increasing the business’s research activities. This calculated R&D credit is used as a dollar-for-dollar offset of federal income taxes related to the business. The caveat is that the credit amount is added back to federal taxable income.

New provision to the Tax Cut Job Act

The 2017 Tax Cut Job Act (TCJA) contained a provision which became effective for expenditures incurred in years beginning on or after Jan. 1, 2022, that R&D costs incurred are no longer allowed as an immediate deduction for federal income tax purposes. Rather, R&D expenditures incurred must be capitalized and amortized over a five-year period at minimum. R&D expenditures incurred for activities that were performed outside of the United States are subject to an amortization period of 15 years.

In both situations, the amortization period begins with the midpoint of the taxable year in which the expenses were paid or incurred. The new mandatory capitalization rules also apply to software costs, regardless of whether the software is developed for sale or license to customers or for internal use.

Effects of the TCJA changes

The TCJA R&D mandatory amortization provision eliminates the ability to immediately expense R&D. This has a significant impact on federal taxable income and related federal income taxes which generally causes decreases in current cash flows. For example, a business that incurred $1 million of domestic R&D expenditures for the 2022 tax year is only allowed an amortization deduction of $100,000 ($1 million/five years/two for the midpoint convention), as opposed to $1 million deduction if the expenses were incurred in the 2021 tax year. The $900,000 decrease in available deduction emphasizes the impact of the new rules on businesses that engage in significant R&D.

Even though the TCJA changes did not impact the Generally Accepted Accounting Principles (GAAP) treatment of R&D related costs for financial statement reporting purposes for the 2022 tax year, businesses will potentially have significant timing differences between financial statement reporting under GAAP as compared to tax return reporting for the life of the R&D expenses. This will have a considerable impact on deferred tax provisions.

The R&D Tax Credit has not been impacted by the amortization requirement under the TCJA. The new R&D expenditures amortization requirement impact is solely on taxable income. Before January 2022, businesses could take advantage of a significant current tax year R&D deduction and credit simultaneously. With the new capitalization and amortization rules generally resulting in a decrease of current cash flows, the R&D Tax Credit becomes an even more valuable tool in which to take advantage.

The new R&D expenditures capitalization rules will have a significant impact on taxpayers’ 2022 tax liability which will affect the calculation of quarterly estimated payments and extension payments for the 2022 tax year. Though there have been many attempts to repeal or delay these changes, none have been successful.

Citrin Cooperman’s Manufacturing and Distribution team is prepared to help you navigate these changes. For more information, please contact Gregg Wirtschoreck at gwirtschoreck@citrincooperman.com or Ewa Anikiej at eanikiej@citrincooperman.com.

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