Unless legislative intervention takes place prior to December 31, 2021, proposed changes to the IRC section 174 of the 2017 Tax Cuts and Jobs Act (TCJA) will take effect January 1, 2022. For this reason, all businesses should understand the impact that the proposed changes could have on other aspects of federal and international taxes.
Under Section 174, expenditures are considered Research and Experimentation (R&E) expenses if they represent research and development costs in the experimental or laboratory sense. This generally includes all such costs to develop or improve a product, provided the expenses are related to activities intended to discover information that would eliminate uncertainty regarding the capability, method, or design of a product.
Prior to the TCJA, taxpayers could treat section 174 R&E expenditures in any of three ways: deduct the expenses in the year paid or incurred; capitalize and amortize the expenses over 5 years; or make an election under Section 59 to amortize the expenses over 10 years.
Starting January 1, 2022, taxpayers will no longer have the option to currently deduct R&E expenses. Instead, the expenses must be capitalized and amortized straight-line over 5 years for work performed inside the United States, and over 15 years for work performed outside of the United States. The mid-year convention must be used for the first year of amortization. Amortization must continue even if project is disposed, abandoned or retired.
Absent legislative action, taxpayers currently expensing R&E expenditures will likely be required to file an automatic accounting method change using a cut-off method. As of November 2021, the IRS has not issued formal guidance to assist taxpayers making this change.
Taxpayers not currently classifying R&E expenditures as Section 174 expenses should perform an assessment to determine whether they are potentially mis-categorizing certain expenses based upon the broad definition above. Manufacturers, for example, could be required to treat some direct and indirect expenses as Section 174 expenses under the new rules, including wages of employees performing research activities, laboratory supplies, equipment rental, outside contract research, patent perfection fees, and management fees related to research and development.
From a taxable income perspective, losing the ability to currently deduct the Section 174 expenses will result in an increase in taxable income for many taxpayers. This should be taken into account for quarterly estimate purposes. Additionally, multinational businesses should evaluate the impact on other federal and international tax provisions that could be affected by a change in taxable income.
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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.