The Tax Cuts and Jobs Act (TCJA) of 2017 included a provision that requires businesses to capitalize and amortize research and experimentation (R&E) expenses under Section 174 over a period of five years (or 15 years for foreign research). This change went into effect in 2022, and businesses will have to plan for it in the first quarter of 2023 when filing their taxes for the previous year.
This change effectively limits the immediate tax benefit of R&E expenses, as businesses will have to spread the deduction over a longer period of time. This can have a significant impact on a business’s cash flow and tax liability. Additionally, it may require a change in the way that businesses keep track of their R&E expenses, as they will need to be separately tracked and accounted for in order to properly calculate the amortization.
This change will have a significant impact on businesses that conduct research and development in the U.S. or abroad, as they will now need to allocate a portion of their expenses over a period of five (or 15) years, instead of being able to fully deduct them in the year they are incurred. This can lead to a lower tax benefit in the current year and can create uncertainty for businesses in their budgeting and forecasting.
Businesses will also need to review their internal processes and procedures to ensure that they are accurately tracking and classifying their R&D expenses as Section 174. They will also need to consider how they will implement the amortization process and how it will affect their financial statements.
Under this change, any Section 162 expenses that are in fact related to research and development are now required to be classified as Section 174 and thus, amortized over five (or 15 years). Guidelines for accounting method changes were outlined in Rev-Proc 2023-11. With these new requirements, taxable income will increase – in some cases quite significantly. The Research Tax Credit will be a strategy to help mitigate this impact.
If these guidelines stay in place, the IRS may target taxpayers who have taken the Research Tax Credit in the past, or potentially target industries that are known to take the Research Tax Credit, to verify that they are following the new amortized changes with the 174 guidelines. It was reported last year that IRS Exam agents were told that they were to check for Section 174 compliance during Research Tax Credit examinations (and more guidance was pending). Even if taxpayers opt to forego the Research Tax Credit, they will not be immune to not amortizing Section 174 expenditures.
Where there is still hope that a retroactive change can take place for the immediate expensing of these Section 174 expenditures to be allowed, any tax policy change needs to occur within Q1 of 2023. However, until then, taxpayers should plan to comply and take the following steps to prepare:
- Do follow the guidelines outlined in Rev-Proc 2023-11. The IRS may be uncompromising with compliance, and there may be a case for penalties.
- Do not skip a year and try to say that you don’t have any Section 174 expenditures or any Section 41 (Research Tax Credit) claim all of a sudden. Any significant changes to positions on tax returns are red flags and can increase the likelihood of an examination. This cannot be stressed enough.
- If you have not claimed Research Tax Credits for prior years, there is still an opportunity to do so. The rules remained unchanged for these years, so any credits for these years can generate credit refunds or carry forward credits.
- Consult your CPA and other Research Tax Credit professionals. These are uncharted waters that require expert advice.
In conclusion, the required amortization of Section 174 research expenses in 2022 is a significant change that will require businesses to plan and adapt accordingly. Businesses are advised to consult with their tax and accounting advisors to understand the impact of this change, and to ensure they are in compliance with the new guidelines outlined in Rev-Proc 2023-11. Businesses that have been impacted by this change might consider the alternative Simplified Credit or Look Back method which also allows them to claim the R&D credit and may be a more favorable option depending on the company’s specifics. It’s also important to note that this change did not affect the R&D Tax Credit itself, and the Qualified Research Expenses may still be used to claim the credit. However, the way the costs are accounted for has changed. It’s a great idea to consult with a tax professional or accountant to determine how this change will impact your business, and to find out if you’re eligible for the R&D Tax Credit and determine the best method of calculating it.
If you still have questions about the Amortization of Section 174, get in-touch with one of our Tax Engineers and let us support you in claiming the R&D credit.