How Changes to R&D Deductions will Impact your Tax Burden
July 28, 2022
At a glance
- The main takeaway: Changes to Section 174 require taxpayers to capitalize and amortize all R&D costs, which could significantly increase companies’ tax burdens.
- Impact on your business: Companies that have been consistently investing in R&D can expect to pay more in taxes, while companies previously in losses could be at risk of becoming taxable.
- Next steps: Act now by scheduling a consultation with an Aprio advisor to understand the potential impact and devise a strategy to lessen the blow.
The full story:
By now, you have probably heard (or learned in our previous article or webinar) that the long-dreaded changes to Section 174 of the tax code are in full effect for tax years beginning in 2022, meaning companies are now required to capitalize and amortize investments in research and development (R&D). These changes will have unavoidable implications on many companies’ cash flow and taxable positions.
To avoid being caught off-guard by a suddenly larger tax burden, take steps now to understand the critical changes, calculate the financial impact, and formulate a tax strategy unique to your company’s needs.
Understanding the changes
Section 174 governs the definition and tax treatment of R&D costs. Before January 2022, Section 174 was characterized by its flexibility; it provided several permissible methods for the taxable treatment of R&D costs, including the ability to fully deduct those costs in the year they were incurred. Because taxpayers had significant freedom in how they treated R&D costs for tax purposes, especially when those costs were eligible for other deductions or tax treatments, there was minimal scrutiny on how taxpayers defined their R&D costs and where these costs showed up on the tax return.
Beginning January 1, 2022, that flexibility was eliminated. Taxpayers can no longer immediately deduct R&D costs and are instead required to capitalize and amortize all costs that meet the definition of R&D outlined in Section 174 over 5 years for domestic R&D activities and 15 years for foreign R&D activities. Taxpayers must also follow the mid-year convention, which allows only a half-year of amortization in the first and final years, meaning amortization will extend over 6 or 16 years depending on the location of the R&D activities. Additionally, the changes extended specific inclusion to software development activities.
Exploring the impacts
The most glaring impact of these changes is that companies are now required to identify all R&D costs and adhere to the new 174 rules, even if those costs were previously eligible for multiple tax treatments. This will create a significant administrative burden to identify all costs that could be considered R&D and categorize those costs as either domestic or foreign activities. This includes direct costs, such as those included in the R&D Tax Credit, and more ambiguous indirect costs, which could include other overhead costs and costs excluded from the R&D Tax Credit.
The changes will also have far-reaching ripple effects on many companies’ overall tax burden. In general, taxpayers who previously deducted 174 costs in the year incurred should expect a higher taxable income amount. This means that growing companies that have been consistently investing in R&D (including software development) will be paying more in taxes this year, and companies previously in losses are at risk of moving into a taxable income position. Additionally, the effect on taxable income could impact other tax incentives and considerations, particularly relating to companies with international tax implications.
If your company incurred any potential 174 costs, you must also consider the potential changes to your estimated tax payments, financial reporting, provision estimates, and the required change in accounting method. Additionally, these changes will require companies to create an entirely new strategy around documenting R&D costs and activities as due diligence against potential future audits since the IRS will now be incentivized to identify underreporting of 174 costs.
Prioritizing a strategy
The implications of these changes will be resoundingly negative and exceedingly complex. Partnering with a knowledgeable tax advisor will be a critical step toward understanding the full weight of the impact on your company, as well as devising a calculated strategy to lessen the impact. The right advisor can help you analyze your costs to determine which must be treated as 174 costs, model the impact on your quarterly estimated tax payments as well as international and state taxes, and evaluate eligibility for the R&D Tax Credit and other incentives to offset the additional tax burden.
Furthermore, lack of official IRS guidelines and persistent ambiguity in the application of the changes, particularly in how to fully define which costs are considered “incident to” research and development, leaves room for interpretation. You need a seasoned advisor on your side to perform a careful assessment and formulate a tax strategy that will help you minimize the financial impact while still prioritizing compliance with the new laws.
The bottom line
Don’t underestimate the potential impact the changes to Section 174 could have on your company’s tax burden and cash flow. Aprio has the depth and breadth of experience to serve as the interdisciplinary experts you need. Our team of advisors can help create a thoughtful, holistic tax strategy tailored to your company.
- Brace for Impact: Changes to R&D Deductions Begin This Year
- It’s Official: Software Development Included in Tax Definition of R&D
- Webinar: How R&D Expenditures Can Impact Your 2022 Tax Plan and Beyond