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

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