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 Expensing | New 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.
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