Highlights of the January 18 HBK Manufacturing Solutions webinar hosted by Nicholas Demetrios, CPA, MBA, Principal, HBK Tax Advisory Group
R&D credits for Manufacturers was first instituted in 1984, It was not an easily obtainable credit; you had to jump through hoops. But it has been liberalized over the years to encourage research & development to improve products and processes, to the point of being a great tool to reduce your tax bill as well as improve your products and processes.
R&D credit is governed under Section 41 of the IRS Revenue Code and expenses governed under Section 174. All Section 41 expenses are 174 expenses, but not all 174 expenses are Section 41 expenses.
Manufacturing has benefited greatly from credits and expenses. The old rules allowed taxpayers to take all Section 174 deductions currently, but that has changed.
Anyone claiming R&D credits for costs incurred in taxable years as of calendar year 2022 and fiscal years beginning in 2022 has to capitalize and amortize Section 174 research expenses under a half-year convention using a five-year amortization timeline, which because of half-year convention turns out to be a six-year timeline. Foreign research has to be capitalized and amortized over 15 years. This represents a major change to previous ability to take expenses currently.
All costs paid or incurred in connection with software development are now considered Section 174 R&D expenses, and have to be amortized over five years.
There is bipartisan support to changes these rules, but no traction yet on getting something passed. So we’re stuck with these rules for the 2022 tax year.
How to adapt:
Revenue Procedure 2023-11 is guidance on how to institute the changes (though there are still unanswered questions).
If you take the credit the only thing to reduce capitalized expenses under 174 is if credit exceeds the amortization you’re taking on those expenses.
It is imperative to get an R&D tax credit study to substantiate the credit. You have to do an analysis to see which expenses qualify. All 41 expenses are included, plus 174 expenses, such as gross wages and other payroll costs, overhead, supplies, occupancy costs, patent costs, licenses, utilities, and more. Have to ensure that these 174 expenses are amortized over five years. The scope is broad.
Spreading expenses out over five years can substantially increase your tax liability in initial years.
Software developers typically expense costs in the year paid or incurred, but the requirement to amortize over five years could result in creating taxable income before generating meaningful income from the product. This seems to go against the spirit of the R&D credit, to encourage development.
Half-year convention: No matter when you incur expenses, it’s treated as incurred in the middle of the year, cutting your amortized expense deduction in half for the first year and leaving that half for year six. For the initial years of R&D spending, you would accelerate hundreds of thousands of dollars of taxes on a million dollar research expense.
We used to advise in most cases to take the reduced credit. But now you’re better off not taking the reduced credit, because your only add-back if you don’t take it is the excess of the credit over the amortization.
Procedural guidance: Normally would file 3115 to indicate a method change, which includes multiple changes and schedules. But starting with 2022, you must attach a statement with tax return that includes a declaration of the change to current amortization for 174 expenses. Statement will be manual because it is not yet included in tax software.
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