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Since the passage of the Tax Cuts and Jobs Act (TCJA) in late 2017, companies have been working to interpret and implement changes prompted by the new law. Most companies are aware of the legislative change that requires taxpayers to capitalize Section 174 research or experimental (R&E) expenditures for tax years beginning after December 31, 2021, but have been monitoring Congressional legislative activity that could defer the implementation of this capitalization provision.
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The regulations under Section 174 define R&E expenditures as all such costs incident to the development or improvement of a product, process, formula, invention, computer software, or technique. Before the TCJA became law, taxpayers had the option of deducting R&E expenditures in the year incurred or recovering these costs over 60 months. Most taxpayers elected to deduct these expenditures in the tax year in which they were incurred. The TCJA repealed the option to currently deduct R&E expenditures and now requires taxpayers to capitalize and amortize these costs over five years for domestic R&E and 15 years for foreign R&E.
This change in law is effective for tax years beginning after December 31, 2021, and will impact substantially all taxpayers filing federal and Colorado income tax returns. For example, a manufacturer developing improved products and manufacturing processes will be subject to this capitalization requirement.
The requirement to change the method of accounting for R&E costs from a current deduction method to a capitalize and amortize method will increase taxable income in the year of implementation. Therefore, taxpayers will need to account for this change when computing financial statement tax provisions and quarterly estimated tax payments.
Although there is bipartisan Congressional support to defer the implementation of this R&E capitalization provision, the deferral was not included in the recently enacted Inflation Reduction Act or the CHIPS Act. As a result, the last chance for deferral in 2022 depends on whether the post-mid-term election lame-duck session of Congress takes up a year-end tax “extender” package which presumably would include a deferral provision.
Based on the inaction of Congress to date to defer the implementation of this provision, taxpayers will need to evaluate whether they are conducting R&E activities and then compute an estimate of expenditures that will be subject to capitalization. Since most taxpayers will be affected by this change in law, and the likelihood of deferral is unclear, it is important that taxpayers understand the impact this provision will have on (1) federal tax liability and estimated tax payments, (2) state tax liability, and (3) financial statement reporting.
Liza Rothhammer is a Principal in Grant Thornton’s Strategic Federal Tax Services (SFTS) practice. She leads a team responsible for specialty tax projects such as accounting methods, fixed asset, cost segregation, and research and development (R&D) tax credit studies. Her experience extends to federal R&D credit calculations, state R&D credit reviews, FIN48 analysis, R&D studies that rely on statistical sampling, the ASC 730 Directive, and IRS and state examinations.