IRC Section 174: Compliance Rules and Updates

  • By Devin Medrek
    • Jan 25, 2024
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IRC Section 174

Overview

Starting with tax year 2022 filings, taxpayers who perform research and development (R&D) have faced yet another compliance-related challenge in properly accounting for the qualified work they’ve done.  In 2021, the attached statement requirement entailed more detail being filed within amended return filings for refund claims. Now, per the Tax Cuts and Jobs Act (TCJA) of 2017, taxpayers must capitalize their domestic R&D costs as an asset under Internal Revenue Code Section 174, and amortize them over a five-year period (using a midyear convention), regardless of whether the R&D credit itself is being claimed.

In short, Section 174 pertains to the categorization of all research and experimental costs and their treatment. As is also specified within the rule change, foreign-based research costs must be capitalized and amortized over a 15-year period. As a reminder, qualified R&D costs are those associated with research activity under four categories: wages, contractor costs, consumable supply and materials, and ‘computer leasing expenses.’ If have any questions for our experts, schedule a call

Tax Impact of the Rule Change

In relation to the rule change, for profitable, tax paying companies who perform R&D, this likely means a short-term increase in tax liability owed in tax years 2022 and 2023. Prior to the requirement that R&D costs to be capitalized, companies were able to deduct those costs in full (less the amount of the actual credit itself) and claim the credit. For tax years 2022 and onward – currently standing – the credit can still be claimed, but the costs contributing towards the credit must be recognized over five years instead of the year in which they were incurred. Even more reason to claim the R&D credit and help alleviate that increased tax burden.

There are several caveats dictating that the rule change does not have a negative effect for all taxpayers. For instance, certain states like California do not adhere to the rules requiring R&D costs to be capitalized. At the state level, R&D costs can be deducted in full, and the credit can be claimed. Additionally, for companies who incur a taxable loss, capitalizing certain costs (i.e. deducting less in the current year) likely will not lead to an increase tax burden. In addition there are still strong benefits to claiming the R&D credit in the meantime; the general credit offsets income tax paid or due, or can be carried forward for up to 20 years to offset future tax. Alternatively, the payroll credit election can be made based on certain qualification criteria; this allows companies to offset their quarterly employer-portion of payroll taxes paid through Form 941.

IRC-Section-174-Compliance-Rules-and-Updates

Why Companies Should Still Claim

Despite the rule’s short-term negative effect for some taxpayers that has been illustrated, full-scale compliance coupled with claiming the R&D credit is still a tax-saving benefit over the long term. As the credit can be claimed in the current year on a recurring basis (it is not capitalized and amortized, only the qualified costs are) and multiple years’ amortization expenses accrue, the result is cumulative tax savings within five to seven years and thereafter, depending on taxpayers’ tax positions and effective tax rates. Leyton, as always, encourages clients and prospective clients to confer with their CPA on these sorts of tax matters.

Aside from the long-term benefit of continuing to claim the R&D credit and adhere to the capitalization requirements, there is an implicit level of risk associated with not doing so. In simplest terms, the IRS and other governmental entities prefer consistency on the part of taxpayers and their related claims. If a company has consistently claimed the R&D credit in the past, deeming that no qualified work was done in 2022, for example, may create a significant ‘red flag’ upon an audit, wherein the IRS could itself deem the amount of qualified cost that the company should have capitalized. This could lead to an even more unfavorable short term tax impact as opposed to a company engaging in an R&D study to determine its capitalized spend amount itself.

What are the Most Recent Developments?

It is worth noting that hope is on the horizon in regard to the potential revision or temporary repeal of the rules requiring capitalization of domestic research expenses; as it stands, foreign research costs would still require 15-year amortization. Currently, legislative proposals that may cease the IRS’ acceptance of employee retention tax credit applications include a reversion back to allowing R&D costs to be deducted in full during the year in which they were incurred. For the ‘innovation industry’ as a whole, it was estimated last year that the TCJA requirements would cost companies over $68 Billion of additional tax owed in 2023. The intent of the R&D credit in the first place, from the late 1980s to its conversion to permanency in 2015 due to the PATH ACT, was to reward innovative companies in the United States and create a lucrative tax credit for those performing qualified work, which theoretically would lead to additional investment, job growth and increased hiring of U.S.-centric employees vs. utilizing workers overseas.

Until the proposed legislation is enacted, we strongly encourage companies to remain compliant within the capitalization rules and continue to claim the R&D credit concurrently. We at Leyton are happy to explain, elaborate, and ultimately work with any company who is performing qualified research. The Leyton team continues to monitor developments regarding the rule change and its possible temporary reversal, and will provide any updates accordingly as the weeks and months progress.

Author

Devin Medrek

Senior Tax Consultant, Tax Team Leader

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