CHANGES TO THE 174 DEDUCTION ARE
What is the difference between 174 and the R&D credit?
On December 22, 2017, the Trump Administration signed into law, “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” (“tax reform” or the “law”). A significant component of this legislation included a provision that changed the manner in which 174 expenses (Research and Experimentation or “Research and Development” expenses) can be deducted by taxpayers for tax years beginning after December 31, 2021.
Companies are Required to Amortize Research and Experimentation/Development
Under current law, Section 174 generally allows taxpayers to deduct Research and Development expenditures as the amounts are paid or incurred during a tax year; alternatively, taxpayers may elect to capitalize and amortize these expenditures over a period of no less than 60 months. For most companies claiming a Research and Development Credit, it made more sense to deduct the entire amount in the year expensed, as this would lower taxable income.
For amounts paid or incurred in a tax year beginning after December 31, 2021, the law will require taxpayers to capitalize and amortize IRC Section 174 research and experimental (Research and Development) expenditures over a five-year period, beginning with the midpoint of the taxable year in which the expenditure is paid or incurred.
The new provision will impact taxpayers treating Research and Development costs as deductible expenses by no longer enabling them to recover all costs incurred in the year in which they are incurred. Accordingly, taxpayers currently deducting Research and Development costs in the year incurred will be required to file an Application for Change in Method of Accounting (Form 3115) to begin capitalizing and amortizing such costs for tax years beginning after December 31, 2021.
Additionally, costs for research conducted outside of the U.S. will be amortized over a 15-year period. Further, expenditures for the development of any software will be treated as Research and Development expenditures. For purposes of this rule, software development costs are included in the definition of Research and Development expenditures. This means that many software companies are going to be affected in two major ways – first, that any overseas development will need to be quantified and included and second, that the amount of expenses incurred through overseas development will be amortized over a 15 year period – three times longer than domestic expenses, and reducing the amount of deduction further.
Decreasing Deductions and Increasing Taxable Income
These changes will mostly affect taxpayers who claim the Research and Development Credit by decreasing the amount of deductions available via 174, and thereby increasing taxable income – especially for software companies which utilize overseas development activities. In some situations, this increase may be significant, along the lines of a 50% increase, or taking a taxpayer from a net loss to a net profit position.
Taxpayers need to know that going forward, additional information will need to be gathered that they were priorly not used to gathering for the Research and Development Credit. These data include development costs incurred outside of the United States, and data that can be delineated between design, construction, and testing phases of research. By breaking out expenses in these ways, taxpayers might be able to claim some expenses as qualified research expenses (QRE) – which will then need to be capitalized and amortized – and others as cost of goods sold, to increase deductions.
Additional items to consider are that qualified expenses are treated differently under section 174 than they are in section 41 – namely, that there are no provisions for “substantially all” when considering wages, and that there is no reduction or “haircut” for contract research expenses. This means that a separate calculation will need to be completed – one that adjusts any wage QRE to specific percentages, and that adds back any reduction in contract research expenses. This separate calculation will provide the taxpayer with the number they need for the capitalization and amortization now required in the new section 174.
The Bottom Line
While these changes affect many taxpayers who have come to regard the Research and Development Tax Credit as a dependable component of their financial planning, most taxpayers will feel the biggest differences in the first two years. However, as the years pass on the amortization the deduction amount will eventually level out. – meaning that the value of the deductions and the Research and Development Credit will negate the dips of the early years of the amortization.
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