R&D capitalization and amortization are here, and we recommend planning as though it’s here to stay. Since the 1950s businesses who’ve incurred R&D expenses under Section 174 have been able to deduct them as incurred. Unfortunately, the Tax Cuts and Jobs Act (TCJA) of 2017 changed this for tax years starting in 2022. Like many in the R&D Credit and tax accounting spaces, we expected that R&D amortization would be done away with or at least delayed, but the time has come to start planning.
Even though drafts of the Build Back Better Act (BBBA passed in August 2022) did attempt to push R&D amortization out to 2026, those changes did not make it into the final bill. While it is possible the deadline will be pushed out with another piece of legislation, at this point we recommend planning for the impact as though it won’t be. Taxpayers currently taking advantage of R&D expense deductions could be hit with an increased tax liability.
What’s Different About R&D Capitalization
The TCJA legislated that R&D costs must be capitalized and then amortized over a period of 5 or 15 years for domestic and international costs, respectively.
Historically, taxpayers deducted the full amount of their non-capitalized R&D expenses in the year incurred. Starting in tax years beginning after 12/31/2021, this deduction will be spread out over a period of years. This reduces the value of the R&D expenses in the current tax year and can impact taxable income.
R&D Capitalization Broken Down
How it Used to Work
The current process is relatively straight-forward: whatever you expense as R&D, you can write that full amount off for the tax year in which the expenses are incurred. Often this leads to a limited or nonexistent tax bill for start-up companies heavily investing in R&D.
For example, if a company has $1 million in revenue and $2 million in R&D expenses, it will have a net loss of $1 million and therefore do not generate any current year income tax liability.
How it Will Work
Taxpayers who usually depend on R&D expense deductions may be hit with a surprise. They will only be able to write 1/5 of the amount of domestic expenses or 1/15 of expenses for global expense. In addition, because of the requirement to use the mid-year amortization convention, the company will only be allowed half of the deduction in the first year (the other half comes in year 6 or 16).
Let’s apply the new guidelines to the same $1 million dollars in revenue and $2 million in US R&D spend used above. Now we must capitalize and amortize, deducting $200,000 in 2022, $400,000 from 2023-2026, and $200,000 again in 2027. In this case, for 2022 our equation is $1 million revenue – $200k amortization = $800k in revenue. At the corporate tax rate of 21%, the income tax due is $168k and a substantial impact for businesses if not planned in advance. The deduction for the remaining $1.8 million isn’t gone, it’s just spread out over several years.
Note that if a company’s R&D spending is flat, in the 6th year, the carried forward amounts from the 1st – 5th year will add up to the amount that would have been deductible prior to the change. This effectively creates a “phase-in” period for all companies from 2022 through 2026 and any start-up in their first years.