174 CONSIDERATIO174 IMPACT, 2022 Q1 CONSIDERATIONS, AND IMPLICATIONS ON FLOW-THROUGH ENTITIES
CFO Services has been writing about the upcoming 174 capitalization requirement (“174-change”) for a long time. In fact, one of the first newsletters was back in the spring of 2020, almost 2 years ago. Now the change is quickly approaching, especially with upcoming 1st Quarter tax estimates for 2022. Taxpayers will want to review what specific items do flow-through entities (S, LLC, and Partnerships) need to consider.
Brief Summary of the 174-Change
One of the most significant tax changes for many businesses in 2022 is a requirement that taxpayers capitalize and amortize their research and experimentation (R&E) expenses paid or incurred after Dec. 31, 2021, under Sec. 174 (174-change). Previously, taxpayers were permitted to either deduct 174 expenses in the year they were incurred or amortize them over different periods of time depending on the nature of the expenses. However, taxpayers must now capitalize and amortize all 174 expenses. The relevant amortization period is five years for research conducted within the United States or 15 years for research conducted outside of the United States.
Legislative proposals have been introduced to modify the application of Sec. 174. The most recent draft of the “Build Back Better” bill contained a provision that would defer the effective date from 2022 to 2026. However, this bill has stalled in the Senate, and any legislative changes to Sec. 174 face a highly uncertain future.
1st Quarter 2022 Consideration
The most immediate impact of the 174-change will be on quarterly estimated tax payments, beginning with the first quarter of 2022. Corporations and individuals, including sole proprietors, partners, and S corporation shareholders, generally must make quarterly estimated tax payments if they expect to owe tax. If a taxpayer doesn’t remit an accurate estimated tax payment, the IRS may apply an underpayment penalty for each quarter that the taxpayer doesn’t remit an accurate payment of estimated tax.
It is important to determine the methodology to be applied for estimated tax projections during 2022, such as calculating the actual impact of Sec. 174 or utilizing a high-level estimate based on assumptions. Also related is any assumption as to whether quarterly estimated tax payment calculations will be based on current year or prior year taxable income. Depending on certain facts and circumstances, some taxpayers could be required to pay estimated taxes, which in the past was not required.
With the 174-change impacting taxable income, this will require shareholders to determine if this will change their tax impact for 2022. Here are a few examples that could drive different decisions for 2022.
Flow-through entities (“flow-through”), which would include S-Corporations, LLCs, and Partnerships have always had differences from their C-Corporation sibling, because the tax is determined at the shareholder or individual level.
Large Increase of Taxable Income/Smaller Losses
Depending on the type of industry and business expense profile, some flow-throughs could increase their taxable income by 50%. This could also equate to reduced losses by that same amount as well. This large increase in taxable income might trigger tax to be paid on those flow-throughs which historically had not been planned for. Starting earlier to model out if the 174-change will change tax significantly at the shareholder level is important to identify any possible tax surprises.
Large Increase of Taxable Income/Smaller Losses
On a positive note, at the shareholder and/or individual level there might be R&D credit carry forwards they can use. Positive taxable income is required from the flow-through to utilize the R&D credit at the shareholder level. If there is a large change in taxable income from the 174-change, it could be offset at the shareholder tax level because now they can offset that increase with R&D credit carryforwards.
With all of these changes coming soon, especially for flow-throughs, it is important to get ready for the 174-change in Q1 of 2022 and also look at taxable income changes that might make the R&D credit more valuable.
CFO Services Can Help With Your Research Credit & Tax Incentive Needs
- Through knowledge and perspectives gained working with virtually every industry and type of client (Fortune 500, medium-size and small companies), CFO Services has committed to a strategy of providing a depth of knowledge in a narrow field of focus: business incentives and credits. Overall: CFO Services provides companies with services to identify and secure federal, state and local incentives across the United States
- Federal/State R&D Credits: Helping clients with the R&D credit calculation, documentation, and exam for creating or improving the product/process.
- Multi-State Credits & Incentives: Collaborate with our clients to capture statutory and discretionary state incentives.
- Technology: Both areas of service utilize proprietary technology to streamline the capture, compliance, and management of a client’s business incentives.
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