Future changes to the way companies can take deductions from research and development expenses may make investing in innovation more difficult, particularly for small businesses and startups. Furthermore, these new regulations may have a negative impact on U.S. national security. Business owners should have long-term strategy in mind when determining how to properly classify expenses. Notably, those with expenses falling under IRC Section 174 can still benefit from the R&D tax incentive. More than ever, it’s important to seek advice from an experienced and highly qualified tax firm.
What Is the R&D Tax Credit?
The research and development (R&D) tax credit has been a driving force behind American innovation ever since the passage of the Economic Recovery Tax Act in 1981. This incentive was designed to encourage U.S. businesses to develop new products, processes and inventions. It allows companies to recover a portion of their investment in wages, contractor costs and supply costs as a dollar-for-dollar federal tax credit.
Who Qualifies for the R&D Tax Credit?
Companies of all sizes and in all industries can qualify for the R&D tax credit. In fact, many activities which would be considered day-to-day operations in certain businesses may be eligible for the credit. Due to its broad range of applicability, the R&D tax credit is something that every business owner should at least be aware of.
What Is Section 174?
Section 174 of the Internal Revenue Code (IRC) is a classification for research and experimental expenditures, including those related to software. Any expenditures claimed as part of the application process for R&D tax credits must also be classified as Section 174 expenditures.
How Did the TCJA Change Section 174?
Prior to the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, companies may have claimed Section 174 expenses as ordinary and necessary costs under Section 162 as a same year deduction. However, the TCJA contained a provision stating that, beginning in 2022, businesses will no longer be able to claim the full value of the 174 costs as a deduction in the year it was earned. This deduction is now required to be amortized over a five-year period for domestic R&D and a 15-year period for international R&D.
How Does the New Amortization Rule Affect Small Businesses?
The overall value of the R&D credit remains the same, but businesses must now take longer to write off Section 174 expenses, which may increase their short-term tax liability. For large and well-established companies, this may not pose much of an issue. A company with extensive capital and a long-term business plan can afford to spend more upfront without taking the full deduction right away. However, small businesses and startups might now be discouraged from investing in research and experimentation. Attempting to develop a new idea is a risky and expensive venture, and five years is a long time to have to wait to receive the full 174 deduction.
How Does Section 174 Amortization Affect National Security?
Journalists have argued that requiring amortization for Section 174 will make the U.S. less competitive on an international stage. In fact, it may even be a threat to national security. Other countries with better research and development tax incentives may foster innovation in ways that the U.S. will simply be unable to keep up with, allowing them to outpace us in offensive and defensive technology development.
How Can You Prepare for the New 174 Requirement?
While it technically still is possible for Congress to repeal or delay the amortization provision (in fact, there seems to be bipartisan support for preventing this new rule from taking effect), taxpayers should be prepared for the possibility of it becoming a permanent change.
If you plan on classifying expenses under Section 174, the R&D tax credit is still a valuable incentive to take advantage of. However, deciding how to classify expenses is now more difficult than ever. Fortunately, Engineered Tax Services is here to help. Our qualified, professional, licensed and legal R&D community is dedicated to helping business owners optimize their tax returns and improve their financial planning.
We can help you determine the best course of action for your business’s ongoing success. Additionally, we’ll make sure all your paperwork is in order so that you can defend yourself in the event of an IRS audit. Feel free to contact us today for further information.
