One item that has so far failed to make headlines among the many changes in the Tax Cuts and Jobs Act of 2017 (“TCJA”), is the treatment of research and experimental (“R&E”) expenditures under Section 174. This is likely because the change in treatment is not applicable until tax years beginning after December 31, 2021 and, when the TCJA was enacted, this was years down the road and taxpayers were focused on the act’s immediate effects. Now that we have reached 2021, it is important for taxpayers to understand what has changed for R&E expenditures and how to prepare.
Current R&E Expense Treatment
Prior to the changes in Section 174, taxpayers had the option to immediately deduct R&E expenses as they were incurred or to elect to capitalize them and deduct ratably over a period of no less than 60 months, beginning with the month in which the taxpayer first realized benefits from such expenditures. Taxpayers also had the option under Section 59(e) to elect to deduct them over a 10-year period.
Due to the similarity between expenses incurred for software development and R&E expenditures, Rev. Proc. 2000-50 permitted taxpayers to treat these software development expenditures as a direct expense or, similarly to the Section 174 election, to capitalize them and deduct over 60 months (in addition to also permitting a 36-month amortization option).
Notable Changes in the Tax Law to Address
The key change for tax years that begin after December 31, 2021 is that Section 174 no longer permits a direct expense, or immediate tax deduction, for R&E expenditures. Taxpayers will now be required to capitalize and amortize R&E expenditures over a 5-year period (15-year period for foreign research) beginning with the midpoint of the taxable year in which such expenditures are incurred. Note that the beginning of the amortization period differs from the prior law in that amortization will now begin at the midpoint of the year the expenditure is incurred as opposed to the first month in which the taxpayer first realizes the benefit from the R&E expenditures.
In addition, there is no longer any distinguishment for costs incurred for software development that may or may not qualify as R&E expenses, because the new Section 174 now clearly states that any amounts paid for software development are to be treated as R&E expenditures and will be required to be capitalized and amortized over the 5-year period (or 15-year for foreign research expenses).
Taxpayers should be proactive in reviewing their current tax treatment of R&E expenditures. An accounting method change (effectuated via the filing of a Form 3115) may be required for most taxpayers who have historically expensed R&E costs as incurred to change its method of accounting for the treatment of Section 174 expenses.
Planning for the Change in Treatment of R&E Expenses
Taxpayers must be aware of and prepared for the change in tax treatment of R&E expenditures starting with their first taxable year that begins after December 31, 2021. Taxpayers who have historically deducted R&E expenditures as incurred will note a reduced annual R&E tax deduction for costs incurred after the change.
Taxpayers who have incurred R&E and/or software development costs will most likely be required to file a change in accounting method for the treatment of these expenditures due to the change in the tax law under Section 174. This is filed on a prospective basis, meaning there is no change to the treatment of expenditures incurred in tax years pre-dating the year of change and only affects the treatment of expenditures in the current and future tax years. As we get closer to the effective date for this change, there may be additional guidance from the IRS that may clarify the process for effectuating this change in method.
To qualify for the Section 41 research credit, an expenditure must be qualified research as defined in Section 41(d), which has been modified under Section 41(d)(1)(A), now stating that the expenditures must be “specified research or experimental expenditures under section 174.” Section 174(b) defines ”specified research or experimental expenditures” as R&E expenditures “which are paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business.”
With the change from deducting R&E expenditures as incurred to the required capitalization, taxpayers must be aware of the treatment of all costs included in the research credit calculation, such as employee wages, third-party contract research performed on behalf of the taxpayer, and tangible supplies consumed during the research process. All of these expenditures must now be capitalized under Section 174, if determined to be qualified for the research credit. These expenditures will now be under greater scrutiny and, if not treated appropriately, the IRS may disqualify the research credit claim by stating that the expenses were not specified research or experimental expenditures under Section 174 and, therefore, not qualified for the research credit under Section 41.
Now is the time for taxpayers to begin to evaluate the impact of this notable change in the treatment of R&E expenditures. They must be prepared to 1) file a required change in accounting method for next year and 2) account for the tax treatment of R&E and software development costs differently. In addition, this will likely have an impact on other tax calculations that are based on taxable income for which taxpayers should be prepared.
Please contact your Mazars professional for additional information.