2022 was a year of extremes when it comes to tax incentives for research and development expenses. Unfortunately, based on the December 29th signing of the 2023 Omnibus Appropriations Act, it appears the year couldn’t have ended any worse in this respect.
First, Congresswoman Jackie Walorski’s made efforts to have the current research credit doubled in legislation she introduced in the congress in June. Tragically, Rep. Walorski was killed in an automobile accident in July and the bill is currently stuck in committee. So, there’ll be no doubling of the credit for 2022 at this writing.
Second, recall that in order to fund the cost of the act, the Tax Cuts and Jobs Act of 2017 (TCJA) requires the capitalization of research costs that were expensed in the past, and requires that capitalization to begin January 1, 2022. Almost every proposed tax bill since 2017 called for the repeal of this capitalization requirement and many tax prognosticators anticipated that the repeal would have been part of late December’s Omnibus Appropriations Act. Unfortunately, that never happened.
Third, and in anticipation that there’d be no change in the law, the IRS issued Rev. Proc. 2023-11, which gave procedural direction to taxpayers how to capitalize and amortize costs (generally over 5 years) which were previously were deducted.
It’s easy to dismiss capitalization requirement as a “timing difference”, i.e., the otherwise deductible expenses will be amortized and deducted over a 5-year period. If tax rates stay the same, it’s only a time value of money issue; if rates increase, there may actually be a tax benefit and vice versa. That said, it’s important to understand what’s at play and the immediate impact of the required capitalization of research costs.
Research costs have been expensed under Internal Revenue Code (IRC) Section 174 and a more limited list of costs (wages, supplies, subcontracted research costs and some computer costs) qualified for an incremental research credit under IRC Section 41. And existing law requires that research expenses are reduced by the credit taken. Enter the effect of TCJA that requires the capitalization of Section 174 costs. Consider the following common example for the 2022 tax year:
- ABC Company has $3M of qualified research expenses, of which $2M qualifies for the research credit. (Typical expenses that qualify as research expenses under IRC Sec 174 but do not qualify for the research credit are: employment taxes and employee benefits of research employees, patent costs, travel, certain utilities, and some depreciation costs). A rough estimate of the current research credit would be about 7% of the $2M costs, or $140K. However, compared to prior years, the current year federal tax cost capitalizing the research costs is $541K. (Computed: $3M costs less $140K credit/5 years X 4 ½ years deferred X 21% corporate rate). The current year incremental cost for flow-through entities taxed at the highest 37% rate could be as high as $952K.
Remember, the above tax costs are temporary; they will reverse themselves over 5 years, however and as you can see, the up-front tax cost is substantial. Time value of money calculations still prove that taking the credit and amortizing the capitalized costs is still favorable to taking the expense benefit up front, but the benefit is clearly lessened. Unfortunately, there’s not an opportunity to expense the benefit up front. If you have research and development expenses that qualify under IRC Section 174, you’ll be required to capitalize those costs. This is especially concerning as the new law includes all software development costs within those costs required to be capitalized over 5 years. Further, if you’ve identified those costs as qualified research costs in the recent past, you’re hard pressed to now identify those costs as other ordinary and necessary costs. So, what can you do?
- Comply with the law change. Because the capitalization rules have not been repealed, there’s an immediate need to comply with the federal guidelines that were just released December 29th (Rev Proc 2023-11) that identify what a taxpayer needs to disclose on their 2022 tax return to automatically consent to a change in accounting to now capitalize research costs. While the tax filing procedure is relatively simple, the detail that needs to be analyzed for a change in accounting can be voluminous. And there is uncertainty how certain costs will be affected.
- Stay tuned. Although compliance, above, is now the law, much has to be done by the IRS to give guidance and to further simplify the capitalization rules.
- Maintain hope for repeal. The incremental research credit has enjoyed bipartisan support from both sides of the political aisle and this requirement to capitalize the credit clearly reduces the tax benefit. Whether such repeal would be retroactive back to January 1, 2022, seems unlikely at this writing. And the doubling of the credit doesn’t appear at all a priority of this congress.
We will be publishing updates as soon as they are proposed, so be sure to check back! In the meantime, if you have any questions, don’t hesitate to reach out to our dedicated Tax Credit Team.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.