As most of you are aware, there has been a change to the R&D expensing rules this year. This change has caused a lot of confusion among taxpayers. This is especially true in the engineering community – a community of businesses that rely heavily each year on the R&D credit. So, let’s dive into what really changed with the federal research and development credit for 2022 tax purposes.
It is important to make the distinction that we have two things that happen every year related to R&D. One is the R&D tax credit and the other is the expensing of R&D costs. These are two completely different things in your tax returns.
First, the easy one. The R&D tax credit is governed by IRS Code Section 41. There have been no changes to how the R&D credit is calculated under Section 41. I repeat, no changes. Engineering firms will still go through the same process for their 2022 taxes. They will evaluate projects for activity that meet the four-part test. Once that’s determined, they will evaluate contracts for financial risk and right retention. Sound familiar? It should, because it’s the same process you’ve been going through in prior years.
So, now your firm has established a 2022 R&D credit. What’s next? Next is the bad news. What has changed is the expensing of R&D costs.
This expensing of R&D costs has always been governed by IRC Section 174. Prior to the 2022 tax year, taxpayers just expensed these costs. They didn’t even really identify them separately for deduction purposes. There wasn’t a need to. Now, Section 174 requires a taxpayer to identify these R&D costs and amortize them over 60 months. It is an accounting method change required for the preparation of 2022 tax returns. This is the important distinction – the deductibility has changed, not the credit.
Obviously as taxpayers capitalize costs and must defer deducting 80 percent of those R&D costs, it increases tax liabilities significantly. This is a critical issue for the engineering community. Several industry groups, such as ACEC, have recommended writing to your congressional representatives to highlight the massive impact this change is having on engineering firms. The good news is they have started listening. Also, there have been coalitions fighting this change for several years now. On March 16, the Senate Finance Committee reintroduced a bill to reverse this provision retroactively to January 1, 2022. We are confident it will be addressed later this year.
In the meantime, firms must deal with it. A firm needs to look at its R&D activity. If you claim the R&D credit regularly, perhaps start with the labor allocation from your R&D study. Are there overhead and indirect costs to allocate to that labor? Is labor that has no financial risk a factor in your 174 computations? These are questions each firm should consider based on their own facts and circumstances as they look to minimize the impact of 174.
A couple of final thoughts. One, you must perform this analysis whether or not you claim the R&D credit for 2022. This means even if you’ve never taken the R&D credit, you still must make this analysis. There will be an impact on your firm regardless of your history with the R&D credit. Second, you cannot avoid 174 by merely not taking the R&D credit. Actually, taking the R&D credit is more valuable than ever because it is a dollar-for-dollar tax reduction that will help offset this Section 174 tax increase. Lastly, there continues to be wide, bipartisan support to overturn this amortization rule and go back to allowing full expensing of R&D costs.
What can you do to help amplify change on this legislation? The R&D Tax Credit Coalition has created a grassroots tool here that you can use to send a personalized message to your representative in Congress. Please feel free to reach out to Corporate Tax Advisors for regular updates on 174 legislation or if you need help understanding how the 174 rules apply to your business.
Mike Woeber is the president and co-founder of Corporate Tax Advisors, Inc. Contact him here.
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