How State Tax Laws Could Impact the Changes to R&D Deductions
March 9, 2023
At a glance
- The Main Takeaway: Companies juggling the tax implications of changes to Section 174 must also adhere to varying state conformity laws.
- Impact On Your Business: Companies operating in states that do not conform with the law changes may be able to deduct some Section 174 expenditures.
- Next Steps: Schedule a consultation today to begin assessing your R&D expenditures and enacting a plan for Section 174 compliance.
The full story:
The 2022 tax year marked significant changes for companies investing in R&D as long-anticipated tax law changes from the 2017 Tax Cuts and Jobs Act (TCJA) went into effect, requiring these previously deductible expenditures to be capitalized and amortized.
Many taxpayers and practitioners held their breath, waiting for Congress to redact or amend these changes to Section 174 to no avail. Congress has not provided a legislative solution, and taxpayers must comply with the changes.
Brushing up on the Section 174 changes
If you aren’t yet up-to-speed, consider reading through our previous summarization. In brief, here are the highlights:
- The TCJA modified Section 174 for tax years beginning after December 31, 2021.
- Section 174 is broad in nature and includes significantly more activities and costs than those that are eligible for the R&D Tax Credit under Section 41.
- The ability to fully deduct expenditures in the year incurred was eliminated for costs meeting the Section 174 definition of research and experimentation.
- Taxpayers must capitalize and amortize these expenditures over 5 years for domestic expenditures and 15 years for foreign expenditures.
Many are now grappling with the lack of IRS guidance, unclear definitions of included expenses, and conflicting variables, such as state conformity to federal tax law.
Understanding State Conformity
In a very American convention, states have the power to enact conformity laws, which provide a mechanism for overriding or rejecting federal rules around the recognition of income and deductions. Several different types of conformity laws are in effect across the U.S., including:
- Rolling or immediate conformity – these states automatically conform to the tax code as changes go into effect.
- Static or specific-date conformity – these states conform to the tax code as it existed on a specific date and require conforming legislation to adopt federal changes after that date.
- Selective or code-specific conformity – these states conform only to specific sections of the tax code following a convention similar to static conformity.
To add even more complexity, state conformity to Section 174 can also vary based on entity structure, with differences in how pass-through entities and corporations treat these expenditures.
State Conformity and Section 174
Many states already conform to the new Section 174 requirements because they have rolling conformity or a conformity date that clearly includes the TCJA and Section 174 changes; however, a handful of states do not conform either because their conformity date is before the enactment of the TCJA or they have specifically decoupled. There is a third group of states where it is unclear if they conform because their conformity date is after the enactment of TCJA, but before the effective date of the Section 174 changes. For example, here are a few states with known conformity differences that will impact taxpayer Section 174 compliance:
- Tennessee enacted a law in March 2022 that decoupled the state specifically from Section 174 under the TCJA, thus adopting a version of selective conformity to adhere to the previous version of the tax law permitting taxpayers to fully deduct R&D expenditures as incurred.
- Pennsylvania adopts rolling conformity for corporate income tax but has selective conformity for personal income tax purposes, meaning corporations in Pennsylvania must comply with the new Section 174 rules, but pass-through entities can fully deduct those expenditures in the year incurred.
- California is a static conforming state that generally adopts the IRC as of January 1, 2015. Since this version of the tax law predates the TCJA, taxpayers are not required to conform to the Section 174 amortization requirements and may fully deduct R&D expenditures in the year incurred.
This list only provides select examples and is not comprehensive. It is still possible that additional states may update their conformity provisions, as many assumed the law would be amended before the effective date. State conformity requires constant, meticulous research and monitoring, which highlights the importance of working with a knowledgeable tax advisor with state and local tax specialization to ensure compliance with all nuances of the tax law.
The bottom line
The changes to Section 174 have resulted in a highly complex and nuanced area of tax compliance characterized by a complete lack of guidance from the IRS or Congress. The complexities of state conformity is only one example of the potential complications awaiting taxpayers as they prepare their 2022 tax filings and quarterly estimates.
If you believe your company had any expenditures in the 2022 tax year that might be subject to the new amortization requirements, you must act now to prepare. Schedule a consultation today with one of Aprio’s experts.