Businesses conduct Research and Development (R&D) to create new products or services, update existing ones, or to develop or enhance processes that will improve operations. The expenses your business incurs in its efforts to do so are known as R&D expenditures. For businesses, these expenditures can be significant in more ways than one. They determine certain tax compliance obligations and eligibility for specific tax-savings opportunities.
New Mandatory Requirements
Prior to January 1, 2022, most eligible businesses opted to take an immediate R&D deduction for qualified R&D expenditures to reduce their federal income tax in the year the expense was incurred. However, a provision in the 2017 Tax Cut Job Act (TCJA) eliminates the immediate deduction for federal income tax purposes, effective for expenditures incurred in years beginning on or after January 1, 2022.
R&D expenditures incurred in years beginning on or after January 1, 2022 must be capitalized and amortized over a period of at least five years. If the R&D expenditures are incurred for activities performed outside of the United States, they are subject to an amortization period of 15 years. Regardless of whether the expense is incurred for an expense of domestic or foreign origin, the amortization period begins at the midpoint of the taxable year in which the expenses are paid or incurred.
This change may lead to a significant impact on federal taxable income, which can cause decreases in current cash flows. In addition, the new R&D expenditures capitalization rules may have a significant impact on your business’s 2022 tax liability, which will affect the calculation of extension and quarterly estimated payments for the 2022 tax year.
Some businesses are waiting to see if Congress will take action to change this new mandatory requirement. In the meantime, taxpayers should familiarize themselves with how they may be affected.
Defining R&D Expenditures
R&D expenditures are those incurred in connection with your trade or business and represent R&D costs in the experimental or laboratory sense. In other words, expenses for activities that are intended to discover information that would eliminate uncertainty, such as those related to product improvement or development. In general, this also includes expenses for obtaining patents, such as attorneys fees related to a patent application. These expenses can be incurred in surprising ways, such as new architectural designs, or manufacturing process improvements.
When it comes to software costs, the new capitalization rules apply, regardless of whether it’s developed for sale, license, or internal use. Expenditures may qualify as long as they are paid or incurred after production begins but before uncertainty is eliminated.
According to Section 1.174-2 of the Internal Revenue Code, “uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.”
Ultimately, whether an expense qualifies an an R&D expenditure depends on the activity it relates to and its purpose. Expenses incurred in advertising, promotions, or in ordinary testing, such as quality control, efficiency or customer surveys, and management studies, do not qualify.
The R&D Tax Credit
To further leverage the R&D deduction, many businesses have taken advantage of the R&D Tax Credit simultaneously. The R&D Tax Credit provides a stated percentage of qualifying R&D expenditures, including domestic wages, contractors, supplies, and other costs incurred in conducting the business’s research activities. This credit provides a dollar-for-dollar offset of federal income taxes related to the business; however, the credit amount gets added back to the business’s federal taxable income.
While the new R&D expenditures amortization requirement does not directly impact the R&D Tax Credit, it impacts taxable income. And since the new capitalization and amortization rules may result in a decrease of current cash flows, leveraging the R&D Tax Credit to its fullest will be an even more valuable tax-savings tool.
The R&D Tax Credit has become more attainable for businesses since legislation in 2003 eliminated the “Discovery Rule,” which stated that research activities had to be “new to the world.” To be considered a Qualified Research Activity (QRA), your company’s innovation only has to be new to you. The activity must also include testing and evaluation procedures, and it must rely on physical science or hard science, such as computer science or engineering.
ARB’s Business Tax & Advisory Services Teams are here to help. We help business owners understand their compliance requirements, including those related to R&D expenditures, and leverage tax-savings options like those available through federal and state-level R&D tax incentives. Contact me today to learn more or if you’d like to discuss your company’s other tax, accounting, or business advisory needs.
Nick Lagoditz, CPA, joined ARB in 2016 as an associate and became a tax manager in 2022. He provides tax preparation and business advisory services, with a focus on partnerships, real estate professionals, and construction businesses. Previous to ARB, Nick worked at a large international firm for nearly two years.