Complete a Section 174 Compliance Study with Leyton

Background

The Tax Cuts and Jobs Act (TCJA), passed in 2017, entailed a drastic change in the tax treatment of research costs starting in tax year 2022. In short, for research costs incurred by U.S. companies, no immediate deduction shall be allowed. Instead, U.S.-based costs must be capitalized and amortized over a five-year period using a mid-year convention (resulting in amortization over a period of six years), while foreign-based research costs require a 15-year amortization period.  Capitalization and Amortization of research costs are mandatory regardless of whether the R&D Tax Credit is claimed.  As discussed below, it is beneficial to claim the R&D Tax Credit to help offset the additional tax burden that may result from the required amortization of research costs.

Why Claim the R&D Tax Credit?

While the compliance-related necessity of capitalizing research costs is unavoidable, companies’ need for relief of increased tax burdens through tax credits has never been more prevalent. It is easy to see how and why the TCJA’s requirement pertaining to treatment of research costs is unfavorable for most taxpayers. To capitalize and amortize a cost is to recognize the expense tax-wise over a prolonged period, versus immediately in the year in which it is incurred (i.e., taxable income increases in the immediate). Luckily, the R&D Tax Credit and its treatment has remained unchanged by the TCJA; the credit still equates to about 10% of research costs annually and is still utilized as a ‘below the line,’ dollar-for-dollar offset of tax due or tax paid. The TCJA also limited the use of net operating loss (NOL) carryforwards in offsetting tax due. Now, NOL carryforwards can only offset 80% of taxable income in any given year; this further amplifies the value and necessity of tax credits such as the R&D Tax Credit.

The R&D Tax Credit can result in significant benefit to a qualifying company. In the event a company is brand new and doesn’t pay income tax, the payroll election of the R&D Tax Credit can be used to offset quarterly payroll tax payments on a forward-going basis. If a company is long-established but has a taxable loss, then it may still be able to benefit from the R&D Tax Credit.  Due to the mandatory amortization of research costs, the company may find itself in a taxable position and could use the R&D Tax Credit to reduce its tax liability.   If a company cannot take an immediate benefit from the R&D Tax Credit, it may be able to do so in the future since the credit can be carried forward for up to 20 years and may be used to offset future tax owed. If the company is being sold within the near future, it should consider the audit risk of non-compliance, first and foremost. Secondly, ‘banked’ credits increase a company’s valuation, as do deferred expenses such as amortization expense. Both are deferred tax assets which would positively impact the company’s balance sheet in the same manner that tangible assets would.

Section 174 Capitalization: What is it?

To summarize, companies must capitalize and amortize their research costs under Section 174. These research costs not only include costs that are used in computing the R&D Tax Credit such as domestic-based wages, contractor costs, consumable supplies and materials, and ‘computer leasing’ costs that are incurred in association with the research activities, but also include many other line items outside of the R&D Tax Credit costs as listed below.

 In brief, every indirect cost that is attributable to research activities also needs to be capitalized. This includes, but is not limited to, the following:

Leyton’s Section 174 Compliance Study:

In reference to the line items above, only a portion of such needs to be capitalized under Section 174. That amount is intended to represent the portion of the line item that is attributable to the R&D activity. One may ask how an appropriate percentage of such costs is determined. The answer, as one would perhaps assume, is ambiguous and complicated. The IRS’ guidance on such an answer can be gleaned largely from Notice 2023-63, in which it explains the allowance for ‘allocation methods’ of other Section 174 costs. Essentially, any multitude of allocations, or percentages, can be used to determine what portion of the above line items must be capitalized as part of overall research costs, as long as they are ‘reasonable and consistent.’

Practically, this means that extensive data gathering, a deep understanding of the business and technical work being performed, and an in-tune and up-to-date understanding of legislative guidance are of utmost importance. Using a service provider that specializes in the R&D Tax Credit – and thus research activities and associated costs in general – can impact a company more significantly than ever. Where a CPA or in-house accountant may attribute a blanket percentage towards these ‘other cost’ buckets to determine an amount to capitalize, Leyton performs a thorough analysis to determine the lowest acceptable percentages to apply towards capitalization that are reasonably and practically justified.

Leyton’s aim for every client is to maximize the R&D Tax Credit while substantiating the claim from a technical and quantitative perspective and defending such within an audit. For companies’ success and longevity, this includes the goal to minimize the total capitalized amount, while remaining comfortably within the confines of the legislation and its guidance. We help companies maximize their tax relief through business credits and ensure that they correctly adhere to the applicable tax laws.  We achieve this by understanding the code, understanding the businesses with which we work, and understanding the nature of the technical work being undertaken. The objective of every one of our client relationships is to achieve a long-term, mutually beneficial relationship. This requires that every engagement be a win-win.

IRS Enforcement:

The IRS expects to grow its workforce significantly through 2025; currently standing, it employs about 90,000 individuals full time, and that number is expected to increase to 105,000 or more by 2025. The primary purpose of this increase is to ‘address high-dollar compliance issues.’ Taxpayers with income over $10 million had about a 9% chance of being audited in 2018; the goal is to increase that percentage. Lastly, starting in October of 2023, the interest rate levied upon tax underpayments was 8%, compounded daily. Companies in certain industries are especially susceptible to such risk based on the nature of their business. Product development, clinical trials, patent filings, manufacturing, and software are just a few of many industries that, based on the nature of business, are almost certainly performing R&D and will have costs to capitalize.  In short, failing to properly capitalize research costs is a major audit risk for taxpayers, which carries with it the possibility of extreme financial punishment.

Contact Leyton today to pursue an R&D Tax Credit study, and to make sure costs are being capitalized properly and in an optimized manner, simultaneously!