Beginner's Guide to IRS Code Section 174: Amortizing R&D Expenses for 2022 and Beyond

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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.

Key Takeaways

• Mandatory Amortization: Starting in 2022, all R&D expenditures must be capitalized and amortized over five years (domestic) or fifteen years (foreign).
  
• Increased Cash Flow Planning: Companies need to plan for the delayed tax benefits due to amortization.
  
• Broad Definition: R&D expenditures include direct costs (wages, supplies, contract research) and indirect costs (rent, insurance, subscriptions, etc.).
  
• Compliance is Crucial: Accurate tracking and reporting are essential to avoid penalties and IRS audits.

What is R&D Capitalization?

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 spread out the cost over several years instead of taking an immediate deduction. This approach can increase your company’s reported profitability, which is ideal for startups looking to impress investors and creditors. Traditionally, most businesses elected to deduct qualified R&D expenses in the same year they were incurred, reducing their income tax liabilities in that year.

What's Changed?

The 2017 Tax Cuts and Jobs Act (TCJA) brought significant changes to how R&D expenses are treated, starting in the 2022 tax year. Here’s a breakdown of the key changes:

• Capitalization Requirement: Instead of deducting R&D expenditures all in one tax year, the taxpayers must now capitalize and amortize these costs over five years (for domestic R&D) or 15 years (for foreign R&D). This means the taxpayers spread the deduction over several years, reducing the immediate tax benefit.
• Software Development: Any amount paid or incurred in connection with software development is now treated as an R&D expenditure under IRC §174.
• Mid-Year Convention: All of the R&D expenses incurred in a specific year is considered to have incurred at the mid-year of the tax year.

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 (for domestic R&D). So, you would have $400,000 of taxable income. The remaining $900,000 in capitalized R&D expenses are deductible over the next five years.

Who Does This Affect the Most?

The changes to IRC §174 primarily impact businesses that invest heavily in R&D activities. Here are the key groups affected:

1. High-Growth Tech Companies: These companies often have substantial R&D expenditures as they innovate and develop new products. The new rules delay the tax benefits of these investments, impacting cash flow and financial planning.

2. Startups and Early-Stage Businesses: Startups that rely on significant R&D to drive growth will find these changes particularly challenging. The delayed deductions can make it appear as though they are more profitable than they are, affecting financial metrics and potentially investor perceptions.

3. Companies Engaged in Software Development: The inclusion of software development costs under R&D expenditures means that tech companies must be meticulous in tracking and capitalizing these expenses.

4. Businesses with International R&D: Companies conducting R&D outside the U.S. face an even longer amortization period of 15 years, further delaying tax benefits.

What This Means for Your Business

The bad news: Your calculated taxable income will likely increase because you cannot use R&D costs incurred during the year to generate immediate losses. Some companies that are not yet profitable may appear profitable on paper. This means your startup might reach profitability earlier than anticipated, at least in the eyes of the IRS, potentially missing out on Net Operating Loss (NOL) deductions.

The good news: Although these changes affect IRC §174, IRC §41 (the tax code section that allows for R&D tax credits) remains unchanged. In fact, it's become more valuable. Even though you must capitalize all R&D expenditures, those that qualify under IRC §41 can still "get your money back" with a credit, helping to offset some of the tax impact from the new capitalization requirement.

A Few Practical Tips for CFOs and Accountants

• Accurate Tracking: Maintain detailed records of all R&D expenses to ensure accurate capitalization and amortization.
• Cash Flow Planning: Adjust financial models to account for the delayed tax benefits due to the amortization requirement.
• Leverage Other Tax Credits: Explore other business tax credits, like the R&D Tax Credit (IRC §41), to maximize tax benefits.

Frequently Asked Questions on IRC §174 & Amortization

Q: Do I need a Section 174 Study if I already have an R&D Tax Credit Study? A: Yes. R&E expenditures under IRC §174 are broader than R&D expenses defined in IRC §41 for tax credit calculations.

Q: Can I skip reporting R&D expenditures if I forego the R&D tax credit? A: No. While the R&D tax credit is optional, R&D expenditure amortization is mandatory. Not reporting can lead to penalties and IRS scrutiny.

Q: How will this impact my tax liability? A: This depends on various factors. For profitable companies, the new rule will increase taxable income by 90% of the R&D expenditures in 2022, resulting in higher tax liability for the next five years.

Q: Could amortizing be beneficial for me? A: In some cases, yes. For C Corporations with net operating loss (NOL) carryovers, amortizing R&D expenditures might be more beneficial than deducting them immediately.

TaxTaker can help ensure compliance by performing IRC §174 studies to identify R&D expenditures and assist with amortization schedules. With Section 174 specialists on staff who can assist taxpayers in accurately calculating R&D expenditures, TaxTaker can help your or your clients stay compliant with the new tax laws.

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