174 Deduction, Foreign Research Expenses, April 2022 

MITIGATE 174 CHANGES FOR FOREIGN RESEARCH EXPENSES 

Companies with foreign research expenses must account for section 174 changes soon. Beginning in tax years that begin after December 31, 2021, companies with foreign research will have to capitalize and amortize all foreign research over 15 years. This will increase taxable income, so companies need to plan for this change, especially the software industry. But companies can reduce the impact of these 174 changes, by asking foreign research vendors to break out development and maintenance expenses.   

Be Aware – Taxable income will rise and soon. 

It is amazing that the Tax Cuts and Jobs Act (TCJA) passed in 2017, will have a major impact upon companies with foreign research. Starting in tax year 2022, the TCJA requires all companies with research expenses to now capitalize and amortize all 174 deductions. For domestic research expenses, the amortization period is five years. But for foreign research expenses the amortization period is 15 years, triple the domestic timeframe. 

Congress has introduced a bill to modify and delay the implementation of these changes to Sec. 174, with the most recent being included in the “Build Back Better” bill.  Yet this bill has stalled in Congress and there is no certainty in a change being passed. Companies must be ready to not only incorporate these changes into tax policy but find ways to ensure maximum benefit.  

Be Ready – Mitigate the rise in income by breaking out Foreign Expenses  

There is a way companies can help mitigate the increase in taxable income from foreign research expenses. Companies should only amortize foreign expenses that are related to actual development. If a foreign vendor performs both development and maintenance work, a company can remove the maintenance expenses from the 174 deductions and amortize. This distinction provides an opportunity to make sure only the correct amount is amortized.  

To ensure only development work is deducted and amortized under 174, companies should work with foreign research vendors to itemize their expenses, especially those related to development and maintenance work. This might take some planning with foreign vendors, but it could considerably help lower taxable income.   

Companies with foreign research need to take a proactive approach and prepare for an increase in taxable income related to the TCJA 174 changes.  One such way to prepare is for companies to work with foreign research vendors to itemize expense between development and maintenance work, thereby to helping to mitigate the amount of increase in a company’s taxable income by carving out the maintenance work for immediate expensing and reducing the amount of foreign design work to be amortized under 174. 

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 
  • Specialities:
  • 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.

IRS CircIRS Circular 230 Required Notice‐‐IRS regulations require that we inform you that to the extent this communication contains any statement regarding federal taxes, that statement was not written or intended to be used, and it cannot be used, by any person (i) for the purpose of avoiding federal tax penalties that may be imposed on that person, or (ii) to promote, market or recommend to another party any transaction or matter addressed herein. 

174 Deduction, Flow-through entities, March 2022 

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.   

Flow-Through Entities 

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 
  • Specialities:
  • 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.

IRS CircIRS Circular 230 Required Notice‐‐IRS regulations require that we inform you that to the extent this communication contains any statement regarding federal taxes, that statement was not written or intended to be used, and it cannot be used, by any person (i) for the purpose of avoiding federal tax penalties that may be imposed on that person, or (ii) to promote, market or recommend to another party any transaction or matter addressed herein.