Section 174 Increases Taxable
Income for R&D Companies
R&D expenses must now be amortized instead of
expensed in the year they are incurred.
Now companies:
- Must distinguish between foreign and U.S.-based development expenses.
- Cannot treat costs as expenses in the year they’re paid or incurred.
- Must amortize costs over 5 years for domestic and 15 years for international expenses.
- Can expect to pay more in taxes.
Talk with our Experts about Section 174
The TCJA specifically calls out software development expenses incurred in the tax years starting after December 31, 2021—they are no longer tax deductible under Rev. Proc 2000-50. This means software companies performing R&D will need to plan carefully.
What is changing for 2022?
Specified research and development (R&D) and experiment (R&E) expenditures are no longer deductible beginning in the 2022 tax year following the revisions made to Internal Revenue Code Section 174 under the Tax Cuts and Jobs Act (TCJA). The loss of the deduction of current year R&E expenses will create a substantial tax burden for many companies engaged in research or product development, even if they previously had no taxable income
Key Changes for Taxpayers to be Aware of:
Rule through 2021
General reduction options
- Deduct R&E expenditures currently
- Elect to capitalize the expenditures and amortize them over 5 years or more
- Make an alternative election to amortize capitalized expenditures over 10 years
Software development costs options
Software development costs options
- Deduct costs currently
- Amortize the costs over 5 years from the date development is completed
- Amortize the costs over 3 years from the date the software is placed in service (eligible for bonus depreciation)
Rule through 2022
- 5 years
if conducted in the United States - 15 years
if conducted outside of the United States - Amortization begins in the midpoint of the tax year incurred (not completion)
- No deduction is allowed upon disposition, retirement, or abandonment—even failed projects
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How do Section 174 expenses work with Section 41?
According to Internal Revenue Code, Section 41 expenses are a subset of Section 174. Although Section 41 wasn’t changed by the TCJA, because it is subject to Section 174 the treatment of its tax deductions has changed
Previously, research expenditures were immediately deductible for companies. Section 174 reduces the allowable expensed amount and amortizes and capitalizes it over 5 years for domestic, and 15 years for international expenses.
Notable Changes to Expenditures
- It’s no longer optional to claim Section 174 expenses. If you are engaged in R&D, you must categorize your expenses as Section 174 expenses, and abide by the new amortization rules. This will reduce your overall business deductions and increase taxable income, in the current tax year.
- The new amortization period begins with the midpoint of any taxable year that §174 costs are first incurred, regardless of whether the expenditures were made prior to or after July 1, 2022. This is the Half-Year Convention, so only 10% of expense deductions are allowed for 2022.
- The definition of QREs is unchanged, so the R&D tax credit calculation remains the same as before
The 4-Part Test Under Section 174
Section 174 allows for a much broader category of expenditures, such as office staff salaries and patent attorney fees. Even though the TCJA changes made it mandatory to categorize R&D expenses under Section 174, research and development QREs that are claimed under Section 41 must continue to meet the stringent 4-part test.
In the chart below, note the difference between direct and indirect costs.
Companies should consult carefully with their accountants to ensure they’re categorizing expenses correctly.
Direct Costs (174 & 41)
-
R&E Wages
-
Self-Employment Income
-
Employee Benefits
-
General Overhead
-
Raw Materials & Scrap
-
Office / Computer / Laboratory Supplies
-
Equipment Rentals
-
Contractors / Outside Services
-
Cloud Computing
Indirect Costs (174 Only)
-
Rent / Mortgage & Utilities
-
Depreciation
-
Software Development
-
Patent Attorney & Filing Fees
-
Management Fees or Association Dues
-
Other Overhead & Office Expenses
-
Travel & Trade Conferences
-
Foreign & Funded Research
Frequent Asked Questions about Section 174 Changes
Previously, CPAs and taxpayers never had to determine whether or not the businesses expenses were Section 162 or Section 174 because all expenses were fully deductible on a tax return. However, many taxpayers businesses do fall under the Section 174 requirements and will need to amortize their research expenses on their tax returns accordingly.
Taxpayers that have already claimed the R&D tax credit and are electing to forgo the 2022 R&D tax credit to instead fully deduct research expenses as Section 162 expenses (general business expense), should speak to a CPA and closely review your options. We anticipate the IRS will have a way to identify qualified Section 174 industries and taxpayers that are not amortizing their research expenditures. If you have previously claimed the R&D tax credit, suddenly claiming expenses under Section 162 (general business expense) will raise a red flag with the IRS. Research and development companies don’t generally stop doing R&D. R&D expenses should be claimed under Section 174.
Previously, CPAs and taxpayers never had to determine whether or not the businesses expenses were Section 162 or Section 174 because all expenses were fully deductible on a tax return. However, many taxpayers businesses do fall under the Section 174 requirements and will need to amortize their research expenses on their tax returns accordingly.
Taxpayers that have already claimed the R&D tax credit and are electing to forgo the 2022 R&D tax credit to instead fully deduct research expenses as Section 162 expenses (general business expense), should speak to a CPA and closely review your options. We anticipate the IRS will have a way to identify qualified Section 174 industries and taxpayers that are not amortizing their research expenditures. If you have previously claimed the R&D tax credit, suddenly claiming expenses under Section 162 (general business expense) will raise a red flag with the IRS. Research and development companies don’t generally stop doing R&D. R&D expenses should be claimed under Section 174.
Companies should work with their CPA to determine what the best estimated quarterly tax payment amount will be. If there’s no urgency to file this spring, a company should consider extending if possible—in the hopes that these changes are repealed in full or part. As CPAs wait for more guidance from the Treasury, taxpayers can still amend their 2020 and 2021 tax returns to generate unclaimed credits and potential cash refunds from prior years. And companies should look to see when they filed their 2019 tax return as the statute to amend and claim prior year refunds is three years from the filing date (2019 tax return filed in 2020).
The R&D tax credits do expire if they’re unclaimed before statutes expire. It may be beneficial to roll the federal and state credits forward to be used to offset future income tax liabilities that may arise from the changes to Section 174 amortization.
The Tax Cuts and Jobs Act (TCJA), passed in December of 2017, amended Section 174 to require capitalization and amortization of all research and experimental (R&E) costs incurred in the tax years beginning after December 31, 2021 (2022 tax year for calendar filers). Dating back to 1954, taxpayers could deduct their expenses in the same year they were incurred on their tax returns.
Despite the bipartisan support, and numerous bills and acts introduced to repeal or defer the amortization requirements to provide taxpayer relief in the short term, it is unclear whether a legislative fix will be signed into law anytime soon. The TCJA’s stated purpose was to be an economic incentive to bring jobs back to the U.S. Companies that have never had to separate their section 174 expenses from regular expenses will face a new challenge with the recent change.
Section 174 will affect any industry and company that performs research but the software industry will likely take the biggest hit. The TCJA specifically called out software development expenses incurred in the tax years starting after December 31, 2021, as no longer tax deductible under Rev. Proc. 2000-50. Instead, these costs must be classified as Section 174 expenses and amortized as such.
Therefore, any software development company that previously deducted its onshore and offshore software development related expenses will now have to capitalize and amortize these costs over five years, for domestic expenses, and fifteen years, for international expenses. Software businesses that retire, dispose, or abandon a software development related project will no longer be able to fully amortize the remaining capitalized costs
