Research and Development Expenditures: Timing is Everything Under New Tax Rules
Taxpayers should start considering the timing for deducting R&D expenses to prepare for a change in the treatment
Taxpayers should start considering the timing for deducting research and development (R&D) expenses to prepare for a change in the treatment courtesy of the Tax Cuts and Jobs Act of 2017 (TCJA).
Historically, taxpayers been able to elect to deduct or capitalize these costs in the year they were paid or incurred, under Section 174(a) or Rev. Proc. 2000-50. For tax years beginning after Dec. 31, 2021, the revised Section 174 rules will require taxpayers to capitalize and amortize all R&D costs.
Taxpayers will no longer be able to deduct these costs and recoup the R&D investment in the year paid or incurred.
Furthermore, taxpayers will need to track R&D costs by location and determine costs that are U.S.-based versus foreign costs since these now have different tax recovery periods (for example, five years vs. 15 years, respectively) under the capitalization rules. If taxpayers deducted R&D costs in the past, they will be required to make an accounting method change for projects that continue into the 2022 tax year. These changes will create timing differences for recovering R&D costs and could disrupt cash flow and reinvestment in R&D.
The time for taxpayers to start planning for these changes is now. Technology, manufacturing and food and beverage companies will be predominantly impacted by this change in treatment of R&D expenses.
Specifically, Colorado’s breweries and distilleries should pay close attention. The timing and recognition of R&D expenses related to equipment and machinery could mean major tax deductions in the years they were incurred. Often R&D performed on the manufacturing process is capitalized to inventory.
To illustrate, costs may be part of an engineering department that does not identify how much time it spends on R&D functions versus quality control functions. Companies tend to overlook R&D that is capitalized to inventory for both the R&D credit and the Section 174 deduction. Under the new rules, this process R&D should be identified, capitalized and amortized under Section 174 instead of being included in inventory. Taxpayers should act with urgency to evaluate their investments’ eligibility for Section 174, the timing of expenses incurred, and subsequently, documentation needed to support such projects.
Further, qualification for the Section 174 deduction could potentially mean eligibility for federal and state R&D credits (Section 41) in addition to the deductions.
Planning for these incentives requires close review of company budgets, cash flow and ongoing and future projects, as well as current treatment of projects’ costs. Any delay in action could also delay the tax benefits of the deductions for which they are eligible – and potentially the more permanent benefit of the Section 41 R&D tax credit.
Liza Rothhammer is a principal at Grant Thornton LLP. She leads the Corporate Strategic Federal Tax Services team in the Desert Mountain West.