The Tax Cuts and Jobs Act (TCJA) of 2017 made significant changes to the taxation of corporations. These changes included a reduction of the corporate tax rate and dividends received deduction (DRD), modification of net operating loss carryback and carryforward provisions, repeal of the alternative minimum tax and business interest expense limitations which all took effect on January 1, 2018. Other provisions outlined in the TCJA had later effective dates, one being the mandatory capitalization of research and experimental (R&E) expenditures under Internal Revenue Code Section 174. Now is the time for companies to take action since the capitalization and amortization of Section 174 may impact countless taxpayers beginning in taxable years after December 31, 2021.
Previous Treatment of R&E Expenditures
In the past, there were two methods for treating R&E expenditures. Taxpayers could either deduct the expenditures when paid or incurred or they could capitalize and amortize the expenditures over a five-year period. Taxpayers could also write-off remaining project expenses if a research project was abandoned.
The guidelines on the treatment of the costs of computer software were similar to the treatment of R&E expenditures. Following Revenue Procedure 2000-50, taxpayers had the ability to deduct the costs as incurred or amortize over a period of either five years from the date of completion or three years from the date placed in service.
Main Changes for R&E Expenditures
The main changes under the TCJA to the treatment of R&E expenditures are as follows:
- R&E expenditures must be capitalized and amortized over five years beginning with the midpoint in the year in which the costs are incurred. The amortization period is 15 years for foreign (non-U.S.) based costs.
- The cost of abandoned research projects can no longer be written-off and must continue to be amortized over the remaining life of the project.
- Under Section 174, software development costs are specifically included in the definition of R&E expenditures. This will eliminate the ability to use Revenue Procedure 2000-50.
An additional analysis of Section 174 will be needed because of these changes for costs and consideration of potential impacts of mandatory capitalization.
Identifying R&E Expenditures
The mandatory capitalization rules go into effect for tax years beginning after December 31, 2021. This means taxpayers must develop a thoughtful approach for identifying and recording applicable Section 174 R&E expenditures. Section 174 defines R&E expenditures as costs incurred in connection with a taxpayer’s trade or business in the experimental or laboratory sense related to the development or improvement of a product, for activities intended to discover information that would eliminate uncertainty for the development or improvement of a product.
Taxpayers can use the following as starting points when analyzing Section 174:
Accounting Standards Codification (ASC) 730-10-25
ASC 730-10-25 states that R&E expenditures must be recognized as an expense as incurred for financial statement or book purposes. Yet, the identification of book R&E costs, does not include the uncertainty standard required under Section 174. As a result of this, taxpayers might need to incorporate further review to assess whether the book R&E costs also meets the uncertainty standard to classify them as Section 174 costs.
Research and Development (R&D) Tax Credit
Section 41 of the U.S Federal Tax Code provides a credit for qualifying expenditures related to research and development performed in the U.S. Qualified research is research with respect to expenses that may be treated as Section 174 costs and meet the four-part test. Qualifying expenditures include wages paid to employees performing qualified services, the cost of supplies and computer rental used in the conduct of qualified research and the cost of contract research for qualified research. Additional analysis will be required to ensure all Section 174 costs are captured and capitalized due to the requirements under Section 174 for both activities and costs are broader than under Section 41, including costs such as foreign R&E, overhead and patent applications.
While preparing for year-end reporting this year, organizations should consider the following:
- Implementation Considerations – The mandatory capitalization of Section 174 costs could be an area of interest in IRS examination, which means having documentation and substantiation of the process used to determine Section 174 costs is recommended. As previously stated, taxpayers should develop a methodology to identify and capture all Section 174 costs.
- Financial Accounting Considerations – Section 174 mandatory capitalization rules will likely create a new deferred tax asset (DTA) for the year ending on December 31, 2022. This DTA will need to be measured and recorded within the year-end financial statements. Taxpayers should determine whether a valuation allowance will need to be recorded to offset this DTA.
- Estimated Tax Payments – Taxpayers may see an increase to taxable income and higher estimated tax payments for 2022 due to the change from immediately deducting Section 174 and internally developed software costs to mandatory capitalization and amortization. Taxpayers should make sure their 2022 estimated tax payment calculations include the impact of this change, review for the potential underpayment of estimated taxes for the year and consider any adjustments to cash flow planning.
- State Tax Conformity – Each state may have different treatments for the Section 174 mandatory capitalization rules. With regards to the federal conformity, there are three categories:
- Rolling conformity – conforms to the federal law automatically
- Fixed-date conformity – the state must update their statues to adopt new federal provisions
- Selective conformity – the state conforms to certain federal provisions selectively. The state conformity rules will need to be reviewed for each state’s tax filing to determine conformity to the federal mandatory capitalization requirements.
- Accounting Method Changes – Changing to mandatory capitalization may require an accounting method change for federal tax purposes. This change currently requires an advance consent procedure, but guidance is expected to provide more of a streamlined procedure (such as an automatic accounting method change or a statement to be included with the tax return filing).
Taxpayers are hopeful that the Section 174 mandatory capitalization rules will be repealed, or the effective date delayed through a legislative amendment prior to the end of 2022. It is possible that an amendment could be made through year-end legislation such as a tax extenders bill. However, given the uncertainty, it is recommended that organizations identify and quantify Section 174 R&E expenditures and determine the impact of the mandatory capitalization changes for book and tax purposes, as well as the additional considerations listed above.
About the Author
Carrie Small, CPA, MST, is a Tax Principal at Brown Schultz Sheridan & Fritz (BSSF). She is a leader within the BSSF Insurance Practice, which provides a full range of audit, tax and advisory services to insurance companies across the country. Within the practice, Carrie specializes in providing tax compliance, tax provision and tax consulting services to insurance entities.