Historically, the IRS has supported domestic research and development (R&D) activities by allowing manufacturers and other businesses to expense certain costs immediately while also taking advantage of the R&D tax credit. The Tax Cuts and Jobs Act (TCJA), enacted in 2017, ended taxpayers’ abilities to expense R&D costs as incurred beginning in 2022. Now, businesses must amortize certain expenses over a five-year period and provide additional documentation when claiming a credit. These changes can substantially increase in a taxpayer’s income tax obligation by reducing both the deductions and credit available while increasing the burden of meeting the new documentation requirements.
Applicable IRC Sections
Three sections of the current Internal Revenue Code could affect manufacturers that incur research and development expenses.
Section 174: TCJA ended taxpayers’ abilities to expense R&D costs as incurred beginning in 2022. Given the expiration of the provision, Section 174 of the Internal Revenue Code now requires taxpayers to amortize certain research and experimentation expenses over five years and certain foreign research expenses over fifteen years, effective with tax years beginning after December 31, 2021 (or, with the 2022 tax year). Taxpayers must also include a statement with their federal income tax filing to report their change in method of accounting for these expenses.
Section 41: Section 41 of the Internal Revenue Code allows for a federal income tax credit for businesses that engage in qualified research activities. Eligible manufacturers must meet a four-part test:
Once R&D activity is confirmed to meet the four-part test, the eligible manufacturer can claim certain wages, supply costs, and third-party expenses as part of the tax credit.
While the calculation of the credit has not changed, taxpayers claiming the credit must provide five pieces of information with the tax return, effective for the 2022 tax year:
Section 280: TCJA also amended Internal Revenue Code Section 280C to prohibit taxpayers from taking a credit under Section 41 that exceeds the allowable deduction related to qualified research expenses for the year. If a taxpayer does not elect the reduced Section 41 credit under Section 280C, the excess of the research credit over the current-year research and experimentation deduction reduces the current year amount of expenses capitalized. As a result, electing the reduced credit will no longer be advantageous for many taxpayers.
Many manufacturers expect that these changes will only affect those companies taking a Section 41 R&D credit. However, the expenses covered under Section 174 are broader than those qualifying for a Section 41 credit. As a result, all businesses should be aware of potential changes to their typical recording of R&D expenses, both on their financial statement and income tax returns. Note that, as with many significant legislative changes, guidance is still pending.
Looking Ahead
Bipartisan support exists to delay or repeal the amortization of expenses described in Section 174. A bill has been introduced in the Senate, and a companion bill is expected to be introduced in the House soon. However, changes are not imminent nor guaranteed.However, changes are neither imminent nor assured. Therefore, manufacturers are encouraged to prepare as if the legislation will remain in effect at least for 2022, if not beyond. Taxpayers are discouraged from ignoring their Section 174 costs and discontinuing claims to the Section 41 credit, as this might create questions regarding the accuracy of their income tax returns. Manufacturers might consider extending their income tax returns in order to monitor legislative action in the coming months.
For questions about your research and development expenses, amortization, or tax credit, please contact an HBK Manufacturing Solutions professional at 330-758-8613 or manufacturing@hbkcpa.com.
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