By J.D. Lewis
Any taxpayer designing or developing new or improved products, regardless of who manufactures or produces the product, should assess whether the new IRC (“Internal Revenue Code”) Section 174 mandatory amortization rules apply. Beginning in 2022, taxpayers will no longer have the option to immediately deduct all research and experimentation (also referred to as development) costs in the year paid or incurred. Instead, the costs must be amortized over 5 years in the case of domestic research and experimentation spend, or 15 years for foreign research and experimentation. This change will affect many taxpayers who may have previously miscategorized some of these costs as “IRC Section 162” (ordinary and necessary business expenses),if those costs should have been treated as research and experimentation expenditures.*
Research and development expenditures have historically received favorable treatment under the U.S. Tax Code. IRC Section 174 previously provided taxpayers a choice of either completely deducting a broad range of research costs in the current year or amortizing the costs over 5 or 10 years. Eligible expenses include the costs of obtaining patents, overhead and administrative expenses, as well as direct research and experimentation costs.
A narrower range of research expenses can qualify for the IRC Section 41 research and experimentation credit. The credit rewards taxpayers performing qualifying research in the United States. Generally, only direct research costs such as employee wages, supplies and outside contract research expenses can qualify for the Section 41 credit.
Since some of the same costs can overlap and qualify for both the Section 174 deduction and the Section 41 credit, taxpayers are required to either make a reduced credit election under Section 280C or add back all Section 41 credit eligible expenses on the applicable tax return.
For taxpayers currently deducting Section 174 expenses, the change to mandatory amortization may require filing an automatic accounting method change using a cut-off method. As of the date of this article, the IRS has not issued formal guidance to assist taxpayers making this change. Taxpayers without a robust system in place for identifying Section 174 costs should assess whether they are mis-categorizing costs which should be treated as research and experimentation costs under the new rules and vice versa.
All software development activities will be impacted by the new Section 174 rules. Effective January 1, 2022, software development costs will be treated as Section 174 expenses, subject to 5- or 15-year amortization. Rev. Proc. 2000-50 will no longer apply to most software development but will continue to apply in the case of acquired software.
From a taxable income perspective, loss of the ability to currently deduct Section 174 costs will result in an increase in taxable income for many taxpayers. This increase should be considered for quarterly estimated income tax purposes. Additionally, multinational businesses should evaluate the impact on other federal and international tax provisions which could be affected by a change in taxable income, as well as their quarterly and annual tax provision calculations for financial accounting purposes, which will show in an increase in deferred tax assets subject to assessment for realizability.
*NOTE: Due to the pandemic, current economic climate, and the perceived impact the change could have on domestic research and development spending, there is strong bi-partisan support for retroactively delaying the effective date of the change until 2026. However, barring any legislative action the rule change is currently effective as of January 1, 2022.
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The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.