By Tom Yuen, CPA, MST
Since 1954 taxpayers have been able to fully deduct research & development (R&D) costs during the tax year in which they occurred, if they chose to do so. The option for an immediate deduction was seen as a way to spur innovation. But that option is coming to an end – maybe. Starting in 2022, R&D costs must be capitalized, with costs deducted over a 5-year period if the R&D activities are performed in the U.S., and over 15 years if the R&D is performed outside of the U.S. Software development is included in this new capitalization requirement.
Why the shift away from the R&D deduction that has been in place for nearly 70 years? And why a change that is in conflict with GAAP (generally accepted accounting practices) which normally requires immediate expensing of R&D costs? Blame it on the Tax Cuts and Jobs Act of 2017, which reduced corporate tax rates from a top rate of 35% to a flat rate of 21%. The loss of revenue from the tax rate reduction is being made up in multiple areas, including the change in accounting for R&D.
Although enacted in 2018, the delay in implementation of the new capitalization provision until 2022 was intended to give the federal government time to more fully assess its effect on businesses. Apparently, someone in Congress felt the change was not in the best interest of the country’s business interests. In February 2021, the American Innovation and R&D Competitiveness Act of 2021 was introduced in the U.S. House of Representatives for the purpose of reinstating the immediate expensing of R&D costs. However, at the time this article was written the proposed legislation has not been brought to a vote in the House.
Since it is uncertain that Congress will take any action before the new capitalization requirements take effect at the end of the year, it is essential that you prepare for the change.
Start by implementing accounting processes to identify R&D expenditures (as defined under IRC Section 174) and separating them from other deductible production and administration expenses. Few companies have bothered to go through this process in the past seven decades. But you will no longer be able to aggregate R&D costs with other items that can be expensed.
Next, make sure you will have more cash available to cover estimated tax payments. The 5-year (or 15-year) capitalization period will mean an increased tax liability due to the deferred deductions.
Previously taxpayers have been required to file an automatic accounting method change if they elected to switch from expensing to capitalizing R&D costs. It is not clear how the IRS will handle the change once it is a requirement. You should work with a qualified tax advisor on the effects of the various options for the change.
The timing of the deductions for income tax accounting purposes may not align with the timing of deductions for GAAP accounting. This will likely require an adjustment to account for deferred tax assets attributable to the capitalized R&D costs.
For a variety of reasons, businesses often abandon an R&D project prior to completion. Previously companies were able to write off the remaining basis of R&D costs when they shut a project down. Now, however, they will be required to continue to amortize an abandoned project over its remaining useful life.
What About R&D Tax Credits?
Many companies that have benefited from both federal and state R&D tax credits (IRC Section 41) will now have to examine how capitalizing R&D expenses will impact these credits. This could also present an opportunity to identify other R&D activities which might qualify for the R&D tax credits.
There is much more to be done to prepare for the switch from R&D cost expensing to capitalization. For example, there are multiple implications affecting the foreign-derived intangible income deduction, foreign tax credits, and qualified business income deductions in relation to the new capitalization rule. That’s why it is essential that you contact a qualified tax advisor now to begin the process so that you will be ready on January 1, 2022. Just in case Congress fails to take action to bring back the expensing option.
Tom Yuen is a partner with Gray, Gray & Gray, LLP, a consulting, business advisory and accounting firm serving a wide range of industries. He can be reached at email@example.com or (781) 407-0300.