This harmful change in tax policy is going to impact the AEC industry, and may even put many small firms out of business.
Architecture and engineering firms provide a valuable service to our society. We create, design, innovate, and solve problems. Most in our industry are driven by the professional services we provide, and the challenging and exciting projects we work on. Our industry is asked to implement innovative technologies to improve our society and our nation. However, many firms are now experiencing a new “tax whammy” that could dramatically impact companies’ cash flow and operations. I am fearful that this change in tax policy is going to hurt AEC firms, and even put many small technical firms out of business.
Over the years, AEC firms have been encouraged by industry associations and advisors to pursue the research and development credit. Firms in our industry have hired specialized accountants to review their work and see if it qualifies for the R&D tax credit. According to current data, it appears that more than 14,000 companies in the U.S. applied for the R&D tax credit in 2022.
In order to claim the R&D credit, research and development costs must be calculated, and those costs are reviewed under a four-part test to see what work is eligible for the tax credit. However, the tax changes passed in 2017, while helpful for our industry overall, did provide a provision that starting in 2022, companies must amortize Section 174 R&D costs over a period of five years and only 10 percent of those costs can be deducted in the year these expenses were paid.
For the past two years, there have been bipartisan efforts to pass an extender to delay the implementation of the mandatory requirement to amortize Section 174 costs. Even with bipartisan support in the last session, Congress failed to repeal, amend, or delay the requirement to amortize research and experimental expenditures. Optimism that this bill would advance with the new 2023 Congress was high in February, however, no action has been taken. Many firms are now wrestling with an exceedingly high taxable income, and some may even experience cash flow issues.
What firm leaders may not realize, even if they do not claim the R&D credit, they may still have Section 174 costs with mandatory amortization. The requirement to amortize expenses, while unable to deduct expenses in the year they occurred, is going to put a huge tax burden on small innovative businesses. (See the example below for $100 of revenue that was considered research and development; common for architecture and engineering firms for a portion of their work).
As shown in the table, under the new requirement to amortize expenses that fall under Section 174, for every $100 in revenue earned, from a cash flow perspective, the company actually loses $21.50 and has to pay 900 percent more in taxes because the wages, rent, and expenses are not deductible in the same year. Could you imagine the impact on a business if you cannot deduct the wages in the year they were paid? It is a continuing cashflow nightmare, as the ability to deduct amortized expenses never catches up with the yearly cost, particularly for a growing business.
Why would any business owner in their right mind invest in research and development when they lose money? This short-sighted provision is a major disincentive and will only cause further movement overseas, resulting in the potential collapse of local businesses.
For nearly 70 years, the U.S. has recognized the importance of R&D tax credits, allowing businesses to fully deduct the expenses in the same year they occurred. The previous Congress failed to extend this credit, even though there was bipartisan support for its extension. Hopefully this can be corrected retroactively, so businesses can have certainty and survive in a time of increased interest rates and inflation. Associations such as the American Institute of CPAs, AIA, and the American Council of Engineering Consultants and their members have been strongly advocating for Congress to correct this issue.
The AEC industry is a trusted industry. Please reach out to your representatives in Congress and inform them of the negative impacts to AEC businesses and the overall U.S. economy. Encourage them to retroactively restore the R&D credits and, more specifically, to eliminate the requirement to amortize Section 174 expenses. Even if your firm is not directly impacted, the future of investment in technology in the U.S. will experience a disastrous ripple effect across our industry.
Dan Houf, P.E. is senior principal and president at Harper Houf Peterson Righellis, Inc., an Oregon-owned firm that has been recognized locally and nationally as a top engineering and multidiscipline firm. Contact him at dan@hhpr.com.