Options for Capitalizing R&D expenses for tax purposes, when to do it and why?

Options for Capitalizing R&D expenses for tax purposes, when to do it and why?

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Research and Development (R&D) costs have allowed companies to search for new knowledge and improvements to existing products while taking an immediate tax deduction under Internal Revenue Code §174(a).

Under §174(a) a taxpayer may treat research and development expenditures, which are paid or incurred by the taxpayer during the taxable year in connection with its trade or business, as expenses that are deductible in the current year. Although taking an immediate tax deduction for R&D costs can be beneficial for many companies, there are a few scenarios in which it may be better for a company to capitalize R&D expenditures.

In lieu of taking a current expense a taxpayer may elect under § 174(b) to ratably deduct R&D expenses over no less than a 60 month period in which the taxpayer first realizes benefits from such expenditures.

To satisfy the requirements to make this election the R&D expenses must:

A. Be paid or incurred by the taxpayer in connection with his trade or business
B. Not treated as expenses under §174(a)
C. Chargeable to capital account

S Corporation becoming a C Corporation

S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders. Shareholders of S corporations report their proportionate share of income, loss and credit on their tax returns and are assessed tax at their income tax rates. This allows S corporations to avoid double taxation of corporate income.

Shareholders are limited in the amount of losses that they can deduct under IRC §1366(d). In general, a shareholder cannot deduct losses in excess of his stock and loan basis. Any losses in excess of basis are carried over indefinitely. These carryover losses can only be deducted to the extent the S corporation produces net income in succeeding years or when the shareholder contributes additional capital.

Shareholders who have carried over losses from their S corporation could be at risk to lose the right to offset future income with those losses if the S corporation revokes its election to be treated as an S corporation. For companies that expect to incur losses in the years leading up to an S election revocation, electing to capitalize R&D expenditures can reduce the amount of carryover losses that disappear. Instead, the company can deduct the amortization expense in the succeeding years when it is taxed as a C corporation.

For example, Abe is the sole shareholder of Blonde Corporation and Charlie is the sole shareholders of Dunning Corporation, both corporations have made an S election and both shareholders have zero basis. Blonde Corporation elects to expense R&D expenditures under section 174(a) and Dunning Corporation elects to capitalize R&D expenditures under 174(b). In Year 1 both companies realize the same income and expenses.

Gross income $10,000
Operating expenses ($250,000)
Research & Development Expenses ($500,000)

 

Blond Corp.  Dunning Corp.
Flow-through loss Year 1 ($740,000) ($340,000)

Both corporations decide they need to raise more money in Year 2 and elect to become a C corporation to allow venture capital firms to purchase stock.

Dunning Corp. deferred $400,000 of research and development expenses by capitalizing the expenses over 5 years which can be used to offset income in future years when the taxpayer elects to become a C corporation. Blonde Corp. however, chose to expense the full amount of R&D leaving a $740,000 carried over loss that is trapped at the individual level and cannot be used to offset future income from the company.

Although there is a benefit to be treated as an S corporation to avoid corporate taxes and alternatively be taxed at the individual taxpayers rate, the limitation of one class of stock and the limited number of investors can be a hurdle for a company looking to grow and seek venture capital. Therefore, if a taxpayer expects to become a C corporation in the succeeding years, electing to capitalize the R&D expenses will result in better utilization of the NOLs.

Ryan W. Bixenman, MS Ryan Bixenman, CPA, MS
T (973) 898 9494
[email protected]

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To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

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