New §174 Amortization Requirements: Are Taxpayer R&D Tax Credits in Jeopardy?

Update

Discussions are underway in Washington, D.C. to repeal the required amortization of Research & Experimentation (R&E) expenses over a period of five years and to restore the immediate expensing of such expenditures. To be added to the Innovation Bill as a provision, the Senate voted 90-5 in favor of repealing the ill effects of the mandatory R&E amortization by the Tax Cuts and Jobs Act. 

The overwhelming bipartisan support is pushing for not only the restoration of immediate expensing of R&E expenditures, but to also expand upon and improve the Research and Development Tax credit for small businesses.

While it is uncertain whether the Innovation Bill will pass or not, there is a good chance final passage of the R&E amortization repeal will take effect by year-end. 

Background

The impact of TJCA resulted in widespread changes to the tax treatment of §174 Research and Experimentation (“R&E”) expenditures. §174 R&E expenditures are a highly regarded aspect of the Internal Revenue Code (“IRC”) for companies engaging in innovation. For tax years starting before December 31, 2021, taxpayers had the option to directly expense or amortize no less than 60 months from when the taxpayer first begins to derive benefit from the R&E. Most taxpayers opt to expense immediately to benefit from the full tax deduction (i.e., immediately reduce taxable income).

In what is regarded as an unusual taxpayer unfavorable change, for tax years beginning after December 31, 2021, taxpayers lose the opportunity to directly expense their §174 R&E expenditures and must instead amortize all R&E expenditures paid in a given tax year over a period of 5 years (15 years if foreign-derived). This marks the first time since 1954 where R&E expenditures are not allowed to be fully expensed in the year incurred. This change is expected to make it more difficult going forward for companies to invest in new Research & Development (“R&D”) within the United States.

Will These §174 Changes Impact §41 R&D Tax Credit?

There is no doubt a strong interplay between §174 R&E expenditures and §41 R&D tax credit expenditures. While not every §174 R&E expenditure is a §41 R&D tax credit qualifiable expenditure, every §41 R&D tax credit qualifiable expenditure is a §174 R&E expenditure. 

Now that 2022 §174 R&E expenditures will be capitalized and amortized over a period of 5 years, there is some worry among taxpayers that only the amortized portion of their 2022 R&D expenditures will be eligible for the R&D tax credit, resulting in a significant reduction in their 2022 R&D tax credit figure.

Key Conclusions

The deductibility of §174 R&E expenditures and the ability to take a tax credit on §41 R&D tax credit qualifiable expenditures are two separate and apart sections of the IRC. While §174 R&E expenditures must be amortized over 5 years starting in 2022, the R&D-qualifiable expenses taken for the R&D tax credit will be claimed on their full amounts. This is because §41 focuses on costs directly associated with R&D projects undertaken during a given tax year, namely qualified employee wages, contractor spend, supplies, and cloud computing. The §174 R&E deduction focuses on all R&E spend incurred during the year, both direct and indirect project costs. While the new amortization requirement will have no impact on the R&D tax credit, taxpayers must be mindful that any expense qualifying for the R&D tax credit will also become a §174 expense, necessitating the 5-year amortization of that associated expense.

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