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Another year, another set of new tax laws. This time, we're talking about the changes to research and development (R&D) capitalization that started in the 2022 tax year. Here's what you need to know, how it will impact your business, and how an R&D tax credit can help.
R&D capitalization is the process a business uses to classify R&D activities as an asset rather than an expense. When you capitalize R&D expenses, you can increase your company’s profitability, which is ideal for startups looking to show investors and creditors the true profitability of your organization. Most businesses elect to deduct qualified R&D expenses in the same year as they incurred instead of amortizing the expenditures over at least five years. Businesses benefited from this, as it reduced their federal income tax in the same year they incurred the expense.
However, the 2017 Tax Cut Job Act (TCJA) changed how R&D expenses are deducted and amortized starting in the 2022 tax year. These changes will affect how your business will file its taxes.
Instead of taking an R&D expenditure as a deduction all in one tax year, the expenditure must be treated as an asset and amortized—or spread out—over a certain number of years. Per IRC §174, you can't take R&D expenditures as a deduction. Instead, you must capitalize them over five years (domestic) or 15 years (foreign). You also won't be required to file the Application for Change in Accounting Method form, as the IRS generally waives it. However, you should still submit a statement containing specified information, such as a description of the type of expenditures.
For example, if your company generated $500,000 of revenue and incurred $1,000,000 in deductible R&D expenses in 2022, you would have reported a $500,000 taxable loss. Under the new capitalization rule, you can only deduct $100,000 of R&D expenses. So, you would have $400,000 of taxable income. The remaining 2023 capitalized R&D expenses ($900,000) are deductible over the next four years.
The bad news: Your calculated taxable income will likely increase because you cannot use R&D costs incurred during the year to generate losses. Some companies that lose money may appear profitable on paper. Hence, your startup may reach profitability earlier than you anticipated (at least in the eyes of the IRS). That means you'll miss out on an Net Operating Loss (NOL), even though you're not profitable yet.
The good news: Although these changes affect IRC §174, IRC §41 (the tax code section that rewards certain types of R&D expenses as qualified for an R&D tax credit) remains unchanged. In fact, it's become more valuable—though you must capitalize all R&D expenditures, those that qualify under IRC §41 actually "pay you back" with a credit.
If you're wondering if you qualify for an R&D tax credit for 2023, ask yourself:
If you answered "yes" to any of the above, great! The next step is to see if your expenditures pass the four-part test below, a set of industry-standard guidelines to decide whether certain expenses can be considered qualifying research activities. The four-part test asks you to prove that your R&D activities have a permitted business purpose, eliminating uncertainty, showing developmental iteration, and being technological in nature.
There are four buckets of expenses you can pull from when calculating your R&D credit savings. These include:
Once you determine that your expenses meet the guidelines, you can apply for an R&D tax credit with the help of TaxTaker. Our experts walk you through the process, from helping you collect documentation to when your credit hits your bank account. Remember: No matter the size of your company or development phase, you can still receive an R&D tax credit!
Austen Legler, an experienced marketer and sales professional, has worked with fortune 500 companies, startups, and more. As TaxTaker's Head of Partnerships, he leads the partnership strategy and is focused on building out TaxTaker's partner ecosystem.
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