174 CONSIDERATIONS FOR Q1 ESTIMATES
Companies Need to Be Prepared for Upcoming Changes
The Research and Development Credit (R&D) has been a popular tax credit for years. In taking the credit, the vast majority of companies have taken immediate expensing of the expenses that are deemed qualified and gone on with the filing of company tax returns. With the Tax Cuts and Jobs Act (TCJA) that was passed in 2017, a change was made to how taxable income is calculated if the R&D credit is taken. Starting with the 2022 tax year, all expenses utilized in the R&D credit will now have to be put into section 174 and amortized. This will change companies’ taxable income and require more tracking of expenses. Additionally, this will have an impact on what needs to be disclosed on quarterly filings for publicly held companies, and privately held companies should consider this change in forecasting results.
This IRS rule change will require a change in accounting method so that will have to be disclosed in financial filings. Upon this change all domestic research expenses are required to be amortized over a five-year period. If there is any foreign research, those expenses are required to be amortized over a fifteen-year period. This most likely will be the biggest hit to companies who develop software and outsource some of the work overseas. That topic will be covered in detail in another article from CFO Services.
The good news is the change to taxable income is on the tax side and will not have as big of an impact on financial statements and valuation. There will need to be disclosures to investors, stakeholders, and owners that taxable income will be impacted, and it will require additional planning and resources. So, the company will need to file Form 3115 – Change in Accounting Method to begin the capitalization and amortization of the expenses, but no section 481(a) adjustment should be needed, though the IRS has still not issued guidance on the issue. The bigger issue is the administrative burden of creating and keeping up the amortization schedules as well as being more diligent and recording more detailed information with regard to the expenses. In the past, foreign research expenses have not been part of the R&D credit study because those expenses were not able to be qualified for the credit. Now, under 174 the expenses must be tracked and amortized over the fifteen-year period. Where this could impact financial statements is if the additional work requires additional administrative costs. This could include having to hire additional staff or require outsourcing some of the work to contractors or consulting firms. Time will need to be spent with outside vendors to determine what work is being done overseas, and whether it can be broken out between design and maintenance activities.
Some company owners or investors may want to know the impact this new regulation will have on the company tax return. The tax provisions that get prepared should start to incorporate these new regulations. The best way to start this process is to take the prior year credit study and make the calculation changes for the differences between Section 41, the R&D research credit, and Section 174. Under Section 174 there is no substantially all rule, so any wage expenses need to be taken at the specific amount that was qualified. For example, if an employee was qualified at 85% for the R&D credit study then for the credit they would appear as being 100% qualified, but under 174 the wage expense would be 85%. Additionally, contract research under Section 174 does not have a “hair cut” to 65% of the expense, so that will need to be adjusted to determine the 174 expenses. The hard part will be determining the amount of foreign R&D expense since that has likely not been tracked in prior years. Estimated tax that must be paid will be higher than in previous years due to this amortization of expenses.
The Build Back Better bill that failed to pass Congress did have a provision within it that would have pushed this change out another five years. Depending on what happens over the next couple of months there is a slight chance that it could be taken up apart from the bigger bill, but this is not likely. So, start planning and putting systems in place now. CFO Services can assist in this process as you calculate your new quarterly tax provision.
CFO Services Can Help With Your Research Credit & Tax Incentive Needs
The R&D Credit provides an opportunity to reduce tax liability. In order to maximize the R&D Credit impact to don’t forget to capture all the expenses that should qualified, especially wages that are direct support. To learn if you’re eligible for the R&D Credit or have more questions related to qualified direct support, please contact CFO Services.
- 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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