Research Expenses Change for 2022, April 2021

Economics of “Specified” Research Expenses Change for 2022

With 2021 off and running, it is important to highlight the upcoming change for the Research Credit and deduction starting at the beginning of 2022.  The Research Credit (Section 41) and R&D deduction (Section 174) have been utilized by companies for many decades to help build research, improve processes, and launch new products.

Tax reform from 2017 has put a little wrinkle into capturing this benefit, and many of our clients have asked about the economics and effects of the change.  Previously, if a company wanted to claim the Research credit (41), they were not required to claim the corresponding R&D deduction (174).  Companies would still receive the deduction for wages, supplies, and contract research claimed under the credit but typically deduct them under section 162 as ordinary and necessary business expenses, treat them as cost of goods sold, or capitalize them.  Either way a company could gain the immediate deduction of the full amount of the expense.

With the tax law change, and starting in 2022, companies will only be able to claim the research credit for expenditures that “may be treated as specified research or experimental expenditures” under section 174.  Additionally, under 174 a company is required to capitalize and amortize the deduction over five years.  Under these news changes, in order to claim the Research Credit, a company will be required to capitalize and amortize the deduction, instead of immediate expensing. 

Economics & Impact of the Change

The next question in the tax law change, is evaluating the two choices companies have with regards to research expenses. 

  • Immediately expense the cost under another section, BUT lose out on claiming the Research Credit; or
  • Amortize the cost under section 174 and claim the Research Credit

At first it might seem that immediate expensing is the most desirable, but the amortization is an overall timing issue that is only impacted by inflation or the time value of money.  Since inflation has been historically low, and within the next five years looks to stay historically low, that difference is very small.  Second, a taxpayer loses the credit fully if they choose immediate expensing which can’t be recovered.

Below is a comparative example for a company to demonstrate the economics of this change.  Here are a few assumptions within the example.

  • Utilizing a 1.5% discount rate
  • Research Credit is calculated using the simplified method
  • Using 21% as the corotate tax rate
EXAMPLE of “specified” research economics   
 Immediate ExpensingNew 174 “specified expense”Difference
    
Amount of Expenses$100,000$100,000 
    
Current Year Deduction$100,000$20,000 
Remaining NPV of Deduction  $0$75,653 
    
Total Deduction$100,000$95,653 
Tax effective Benefit$21,000$20,087($913)
    
R&D Credit (Year 1)$-$5,530$5,530
    
Total Benefit$21,000$25,617$4,617

From the above example, even with the new tax law change, a taxpayer who has R&D costs should be deducting these as a “specified expense” and claiming them as a Research Credit.  If the company chooses the other method, they will lose any ability to claim the Research Credit, which is shown above to be approximately 22% of additional tax benefit. 

In 2021, companies should start looking at their current accounting system to start isolating the expenses for research that will need to be “specified” and captured for the Research Credit.  This will allow these companies to make an easy transition to the new method and not miss out on the additional benefit for claiming the Research Credit.

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. Providing tried and tested methodologies, our professionals can help almost any business research, identify and comply:

  • Research and Development Credits
  • Multi-State Tax Incentives and Credits
  • State Sales and Use Tax
  • Strategic Alliances
  • Workforce Training Programs

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Qualified Wages Related to Direct Support, March 2021

Missing R&D Expenses: Don’t forget Support Activities

If a company files for the research credit, they would be aware of the “Four-part” test for qualified activities. Part one, a qualified activity has a purpose to create or improve a company’s product or process; part two, these improvements are made through the application of hard sciences principles and techniques; part three, there are uncertainties as to how to use or design the improvement with the hard sciences; and part four, there needs to exist a process to evaluate design and development approach in order to mitigate the improvement uncertainties.

What companies might miss are the types of expenses that can relate to qualified activities, specifically wage expenses. The eligible research expenses for wages fall into three categories of qualified services: those engaged in qualified research; those who are directly supervise, and those who directly support.

Most of the time, companies understand which employees are engaged in qualified activities and even who supervises them. The missed opportunities are usually with employees who directly support research activities. Companies should be willing to look past employees who are directly involved in qualified activities, in order that they not miss employees who, while not fully engaged in a substantially all capacity, are still performing qualified activities.

The R&D Credit states that direct support is anyone who is helping support either those engaged in qualified activities or directly supervising them. Direct support can include employees like technicians, project managers, quality assurance personnel, and assistants. The R&D Credit gives further examples:

  • A secretary for typing reports;
  • A laboratory worker for cleaning equipment;
  • A clerk for compiling research data;
  • And a machinist for machining parts for a prototype model.

Most companies at first glance would probably not have selected a secretary or machinist wages as qualified for the R&D Credit. The important aspect to those supporting employees is that it is direct support. General administrative work would not be qualified, things like accountants preparing checks for engineers, or janitors cleaning the research laboratory.

A good rule of thumb is to look around the employees who are directly involved and see if there are other employees who support the work. It might be surprising what types of employees can qualify for supporting R&D activities.

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.

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. Providing tried and tested methodologies, our professionals can help almost any business research, identify and comply:

  • Research and Development Credits
  • Multi-State Tax Incentives and Credits
  • State Sales and Use Tax
  • Strategic Alliances
  • Workforce Training