As of January 2022, businesses are no longer permitted to deduct research and experimentation (R&E) expenses in full in the year they were incurred. Under the 2017 Tax Cuts and Jobs Act (TCJA), the IRS now requires business owners to amortize these expenses over a period of years. Previously, businesses could deduct R&E expenses in the year they were incurred.
The recent changes to Section 174 will likely increase companies’ taxable income and decrease their cash flow depending on the amount, frequency and location of their R&E related expenses. U.S. companies sending their research and development (R&D) work overseas will experience a greater impact, as their amortization period will be longer.
Starting in 2022:
• Section 174 expenses associated with research conducted in the U.S. will be capitalized and amortized over a 5-year period.
• Section 174 expenses associated with research conducted outside the U.S. will be capitalized and amortized over a 15-year period.
The anticipated decrease in Section 174 deductions highlights the importance of the Section 41 R&D tax credit. While all Section 41 expenses qualify as a Sec. 174 expense, not all Section 174 expenses are credit eligible. The R&D calculation concentrates on direct research expenses such as wages, supplies, and fees paid for contract research. Section 174 expenses include these costs, but they also include indirect research expenses such as facilities costs and depreciation. Companies should closely examine their Section 174 expenses to determine whether any of them can support an R&D tax credit.
Keep in mind there is looming legislation looking to temporarily, or permanently, return Section 174 deductions to their “year incurred” status as they were defined prior to the TCJA changes. This potential diversion should NOT, however, prevent R&D companies from moving forward on their tax planning around R&E expenses.
For more information about changes to Section 174 and how your business can proactively prepare, reach out to our CSH R&D tax experts.