Category: Newsletters

With 2021 off and running, it is important to highlight the upcoming change for the Research Credit and deduction starting at the beginning of calendar year 2022.  The Research and Development Credit (Section 41) and Research and Development 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 that have clients asking about the economics and impact of the change on their credit strategy.  Previously, if a company wanted to claim the Research Credit (41), they were not required to claim the corresponding Research and Development 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.  So 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.  So 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. 

With this 174 amortization requirement, let’s assume we are taking the 174 amortization and also taking the Research Credit.  Below are a few scenarios that will be impacted from this required change in accounting. 

NOLs reduced and/or taxable income increased

174 amortization will take items that are currently deducted in the year and spread them over 5 years.  The requirement is to take these expenses and defer them over the 5 years, creating a timing of the deduction issue.  In year 5 though, it will essentially be caught up as current, because years 1-5 will all have contributed 20% to the amortization calculation. 

Increases taxable income and/or reduction in the NOL will be the result of this amortization.  For companies that have been traditionally generating NOLs and building a Research Credit carry forward, this could be a surprise because the 174 amortization will reduce that NOL. 

This can speed up the utilization of NOLs and increase the need to generate credits.  Companies that have a long-time horizon of NOL utilization, might have it shortened and increase the need to generate credit to offset the increase in tax. 

LBI Directive inconsistency

LBI Directive is related to ASC 730 research expenses reported on the financial.  This method of calculating the Research Credit was created to streamline the process and give the IRS a clear picture of the expenses from the LBI Directive to the Research and Development Credit. 

Even though we have expenses classified as 174 they could still be outside of ASC 730.  Certain wages and supplies, and always contract research are outside the LBI Directive, even though they will be classified as a specified research expense. 

By being outside the LBI Directive these expenses could be scrutinized deeper than those inside the LBI Directive.  The 174 amortization does not guarantee qualification for the Research Credit and will still require in depth analysis of the qualitative documentation.

Foreign Research Expenses

Typically for the Research credit, foreign research is non-qualified.  Especially within contract research expenses, all foreign based research must be removed for the Research Credit calculation.

174 amortization allows for foreign research to be amortized over 15 years which is a special clause in the code section.  The companies will need to bifurcate their foreign research from their domestic research to capture the different amortization amounts. 

If foreign research is amortized this will create a difference between a 174 expense and section 41 research credit QREs.  Typically, companies will think that the 174 and 41 expenses will match, but foreign research can change that direct correlation. 

These are just a few example scenarios of the 174 research expense amortization changes for 2022.  Please contact us in 2021 to start the planning process, as we are helping our clients with the necessary accounting as well as upgrading our software to bring in this additional calculation.

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

IRS 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

With the high demand in housing and multi-use properties currently increasing in sometimes record amounts across the country, it may be a surprise to companies within the Design-Build industries, including Architecture, Engineering, and Construction, which provide the engineering, design and manufacturing processes related to new housing and real estate development that some of these activities can be qualified and claimed as part of the Research and Development Tax Credit. The difficulty with these types of activities – and which is commonly the case related to other manufacturing industries and activities – is the determination of where the design process ends, and production begins. For the Research and Development Tax Credit, the important activities to focus on are those that occur up to the point of when a product, business component or design is considered as “in production”.

For an example – some companies provide the engineering design necessary for the components of a home or other structure – i.e., the walls, the trusses and roof, and floors. The time spent by the engineers to design each component, as well as the time spent combining those components into overall building designs can likely be considered as qualified activities, as long as the four tests – technical uncertainty; process of experimentation; new or improved performance, function, quality or reliability; and based on “hard sciences” such as engineering – are met. In this example, these four tests might be met in the following manner:

• Technical uncertainty – the overall design for a wall is unknown – what the framing design will be; what the materials will entail and what impact those materials will have upon the structural integrity of the wall; what will be the ultimate load bearing capability of the wall and will it meet all necessary specifications?

• Process of experimentation – many design firms utilize advanced software such as CAD to analyze the overall structures of engineered items. Computer simulation is an allowable form of process of experimentation – a systematic, recordable, or observable manner in which to eliminate uncertainty from a design. Additional activities that might fall under process of experimentation in this example might include the fabrication of a prototype wall for actual physical testing of load bearing, or in finding the point of failure; or in analyzing the impact that moisture has on the performance of the wall.

• New or improved performance, function, quality or reliability – even though walls are common and have been around for centuries, the specific application and design needs of walls in new construction can be considered as a new design, especially if the whole of the design (the house or structure) is a new design. It may be perfectly suitable and successful to import a wall design used in other instances, but it is still unknown whether that wall will function as necessary according to specifications.

• Based on “hard sciences” – this test is to ensure that the activity being claimed is not related to sectors of activity considered as explicitly non-qualified – ie., accounting, marketing, human resources, etc. The majority of companies performing these design activities will be basing their work upon engineering and physics principles and knowledge, which are considered “hard sciences.” For example – the physics behind the development of a load bearing wall – evaluating the impact of wind and other natural forces on the structural integrity of a wall design, and what impact utilizing different materials might have on these forces.

Some items of concern other than identifying when the design process ends, and the production process begins including how companies performing these activities structure their agreements with clients and customers. The main items of concern in this area are who retains the rights to the design, and who inherits the risk of performing the activity?

Staying within the example of designing the components of a home or structure, if the company performing these design activities has an arrangement with a real estate development firm to provide designs, and will receive payment regardless of whether the designs are used or if the designs meet the specifications provided by the developer, then these design activities, no matter how complex, would be considered funded research – because the development firm has paid for the rights to the designs, and also inherits the financial risk regardless of the final design.

However, another agreement structure might entail the design firm receiving a portion or “good faith” deposit from the developer, the remaining amount being contingent upon the delivery of an acceptable final design. In this case, any costs for the design efforts that occur outside of the initial good faith deposit would be a risk of the design firm. And the contingency aspect of the acceptable final design also puts the risk inherently with the designer, and not the developer. Regardless of the structure of the agreement, it is very important that when claiming these types of activities for the Research and Development Tax Credit that the agreements be collected as part of the contemporaneous documentation required to successfully defend a claimed credit.

These are just a few ways that Design-Build industries can participate in and benefit from the Research and Development Tax Credit. The main issues to consider are:

• When does design end and production begin?
• If there was a design agreement with a third party, what is the structure of that agreement?
  • Who holds the rights to the design and the risk of the design activity?
• What documentation has been collected to support the claim?
  • Design documents – showing iterations, computer modeling, testing, test reports, photos of prototype testing, etc.
  • Agreements between the Design Build firm and their client/customer

IRS 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