You should know about a potential revision to capitalization rules that could trigger amortization of R&D tax credits, rather than make them available for immediate expensing against tax liability.
The End of Immediate Expensing?
This change to R&D tax credits may or may not be coming, but there is a chance it will become a reality on January 1, 2022. Historically, taxpayers who are granted the R&D credit have been allowed to claim R&D credits and expense the qualifying research activity and supply costs against their current tax liability (there is an expense add-back to prevent double dipping). However, the Tax Cuts and Jobs Act (TCJA) of 2017 eliminated the immediate expensing of R&D costs, starting in 2022.
If this regulation remains in force, taxpayers will be no longer be permitted to enjoy immediate expensing of research costs. For costs incurred in U.S.-based innovation, it will be amortized over five years. Costs incurred internationally will be amortized over 15 years. This change would seriously impact income levels.
However, there’s hope. H.R. 1304, the American Innovation and R&D Competitiveness Act of 2021, seeks to repeal the TCJA ruling; it is part of President Biden’s proposed Build Back Better Act, and it’s designed to delay the amortization rule until 2026.
A case study will enable us to discern the difference this new legislation could make. Let’s say a corporation has invested $100 million in offshore software development, but has only reaped $10 million in revenue. Under current laws, the taxpayer would be judged to have suffered a $90 million loss. But if the TCJA rule kicks into effect next January and is not stymied by H.R. 1304, the IRS would declare that the taxpayer gained a $76.7 million profit instead. What a difference a law makes!
The outcome of this legislative tussle is by no means certain. We may well witness a delay on this amortization rule, since pending drafts of the Build Back Better Act have included the delayed application of amortization until 2026.
If amortization becomes the law, what recourse is there for taxpayers? There are five strategies taxpayers should be marshalling now to counteract for this possibility:
- Cash flow planning
Optimizing cash flow tax planning can offset a potential tax burden. In this case, federal and state loss carryforwards may be helpful. Please note that federal loss carryforwards may be subject to 80% taxable limitations. Taxpayers with loss carryforwards in California may benefit from Assembly Bill 85; for taxpayers with taxable income of more than $1 million, net operating losses are suspended.
Under FASB ASC Topic 740, businesses are required to analyze and disclose income tax risk, so their income tax expense for financial reporting are recognized according to U.S. generally accepted accounting principles (GAAP).
Accounting for income tax under ASC 740 affects how a taxpayer capitalizes R&D costs, regarding:
- Deferred tax assets
- Cash taxes
- Effective tax rate
- The bottom line when assessing new White House tax proposals
- Documenting R&D tax credits
Nothing nullifies a taxpayer’s chances of obtaining R&D tax credits more than insufficient documentation. Meticulously detailed supporting documentation is a non-negotiable! Ascertain that the level of detail in your documentation meets IRS standards. It can also be smart for taxpayers to review their R&D tax credits to ensure they can capture the greatest dollar amount.
- Accounting methods
Savvy taxpayers may also want to consider adopting alternative accounting methods, such as by accelerating deductions or deferring revenue, for instance. By changing their accounting method, if a taxpayer has been employing an inadmissible method of accounting, they can correct it by deferring the correction’s cost over four years, while protecting against prior-year audit adjustments subject to interest and penalties. As a rule, accounting method changes should be considered part of a taxpayer’s overall cash flow strategy.
Technical accounting for R&D cost centers and accounting policies can identify costs that could be recategorized as other general and administrative costs.
Will the amortization rule will become a reality next year? Only a soothsayer would know, but in the meantime, being forewarned means becoming prepared!