It’s become increasingly apparent that Section 174 may be around longer than anyone believed possible.
After being passed by a greater than five-sixths majority in the House, another tax reform bill (HR 7024) is slowly dying in the hands of the Senate. It’s becoming increasingly clear that the crescendo of questions as to “Why has the 174 issue not been remedied?” is potentially no longer the right question to be asking. At present the more apt questions are “Who wins?” and “How will the new law be enforced?” To answer these questions, you need not look further than Washington, D.C., which includes all legislators and our nation’s collectors, the IRS.
While the Employee Retention Credit (ERC) seems to be the focus of IRS ire, it appears to be more of a red herring as the underlying law regarding the ERC is particularly favorable to taxpayers. An investment in auditing legitimate claims will yield little revenue (though the case may still be made to go after fraudsters) while there are more appetizing adjustments to focus on. Section 174 represents just such an alternative collection vehicle. Millions of preparers inappropriately bypassed or missed accounting for Section 174, assuming legislative corrections would take place and would save them from their detrimental stances. Unfortunately, the much-needed legislation failed to take place, leaving clients and their preparers exposed to extreme jumps in taxable income. If you think audits of R&D tax credit beneficiaries are a lucrative “revenue” generator for federal and state governments, Section 174 revenue generation, i.e. Section 174 audits, will make R&D audit values look like rounding errors.
The enforced capitalization under IRC 174 applies to all companies, regardless of whether a taxpayer took the R&D tax credit allowed under IRC 41. This enables the IRS to examine taxpayers and obtain large adjustments even from those who believed they were safe from Section 174 capitalization. In fact, the IRS has access to large databases of information, which can help it determine whether a company should have had expenses related to research, and flag those companies that obviously didn’t take capitalization into account. Exams can and will be opened to ascertain how much of their expenditures were related to research, and the IRS will enforce the adjustment, resulting in possibly large penalties and unreasonable tax bills. Historically, of the average 20,000 annual R&D tax credit beneficiaries, a third are professional service firms, which the IRS can easily leverage to ascertain industry averages with NAICS/SIC codes, leaving service firms particularly vulnerable to this examination technique.
As an example of just such a scenario, let’s look at a civil design engineering firm that never took the R&D tax credit and paid $1 million in wages in 2022 and $1.25 million in 2023. The taxpayer took the stance in 2022 and 2023 that because they never took the credit or broke out their research component from the rest of their costs, they did not have to capitalize a portion of these expenditures under IRC 174. The IRS can look at industry averages and ascertain the likely percentage of qualified research expenditures for a civil engineering firm (generally between 15 percent and 30 percent), verify that no asset was placed into service on form 4562 in 2022, and open an exam.
Let’s say that the IRS, upon evaluation of a sampling of projects, determines that projects on average contain 20 percent expenditures related to research and development and attributes the amount to both W2 wages and overhead accounts, creating a capitalized amount of $300,000 in 2022 ($200,000 wages and $100,000 overhead) and $375,000 in 2023. This results in $270,000 and $277,500 deduction overstatement in 2022 and 2023, resulting in an underpaid liability (assumed effective rate of about 30 percent) of $81,000 and $83,250 in 2022 and 2023 respectively – a total of $164,250. This also results in a possible substantial underpayment penalty, which would be 20 percent of the portion of the underpayment of tax due to negligence and disregard. With the notices and other information provided for this capitalization component, practitioners may also have this penalty imposed on them for intentional disregard or aggressive stances by not informing their clients of their new requirements to allocate research expenses.
Furthermore, although the IRS attributed a percentage adjustment for section 174, they do not have to adjust for credit that should have been created through the application of IRC 41, the research and development credit. In fact, due to the incredible amount of legislation and tax law surrounding the credit, the taxpayer would need to engage a credit provider to properly identify and amend to receive the credit, identifying appropriate components. If the taxpayer had previously participated in studies identifying these costs, the taxpayer would have been entitled to a $52,293 credit to offset their $164,250 increase in liability. This means that a taxpayer who failed to properly recognize their research expenses could end up $85,143 (not to mention interest!) poorer than a taxpayer who properly reported research expenditures.
It’s starting to appear that despite many legislators’ best attempts to remove this aspect of the legislation it may still end up being the “law” of the land for 2022 and 2023, as retroactive treatment becomes less and less likely as time passes, taxpayers comply, and the IRS collects. Section 174 greatly increases the burden of compliance, however the cost of non-compliance with this requirement is much more substantial for the taxpayer. In effect, this layer of compliance has now become necessary for almost all taxpayers, which could thoroughly undermine and destroy businesses that have taken aggressive stances regarding the application of IRC 174.
A taxpayer should ensure that they are in compliance by understanding the various aspects of the credit and what could be considered to be a research and development expense. They should do their best to claim the credit or identify which costs would be excludable under the rules. In the example above, the taxpayer, with a thorough R&D study, could determine that their rate of qualified expenditures is far lower than the IRS determination. However, without proper documentation of these expenditures, the IRS could easily adjust for a higher amount using extrapolative calculations.
It’s also incredibly important to note that taxpayers who do not take advantage of the credit, while being subject to capitalization under 174, will experience a permanent, negative timing difference that will never be fully recovered. Taxpayers who include the credit will generally see a net positive adjustment and a positive cash flow effect in approximately five years.
It’s become increasingly apparent that 174 may be around longer than anyone believed possible, as it punishes a core American value: innovation. Taxpayers who do not wish to engage in a study every year should contact their senators and House representatives and let them know the damage their inaction causes to the country and to normal, law-abiding business owners doing their best to thrive in the American market.
Eric Tuthill is a tax manager with Corporate Tax Advisors, Connect with him on LinkedIn. Jordan Wilson is director of business development at Corporate Tax Advisors. Connect with him on LinkedIn.
