Tax Treatment of Research and Experimental Expenses During 2022
Written by Steven N. Smith, J.D., CPA
The 2017 Tax Cuts and Jobs Act (TCJA) is the gift that keeps on giving, continuing to create significant challenges for taxpayers and their advisors in implementing tax changes under the TCJA. Another area of established federal tax law for which the TCJA has created significant change is the tax treatment of research and experimental (R&E, also known as R&D) expenses.
Taxpayers have been able to elect to expense or capitalize R&E expenditures since 1954. Under the TCJA, however, R&E expenditures incurred or paid for tax years beginning after December 31, 2021, will no longer be immediately deductible for tax purposes. Instead, businesses are now required to capitalize and amortize R&E expenditures over a period of five years for research conducted within the U.S. or 15 years for research conducted in a foreign jurisdiction. The new mandatory capitalization rules also apply to software development costs, regardless of whether the software is developed for sale, licensed to customers, or for internal use.
The Build Back Better Act (BBBA) passed by the House of Representatives in November 2021, included a provision that would have delayed the effective date for the amendment made by the TCJA until tax years beginning after December 31, 2025. While this specific provision of the bill enjoyed broad bipartisan support, the BBBA stalled in the Senate, making the path forward unclear on any delay of the TCJA provision requiring capitalization and amortization of R&E expenditures.
The more time that passes during 2022 without legislation on this matter, the more likely it becomes that taxpayers will be required to implement this change under the TCJA during 2022. Some tax professionals believe that legislation on this matter, even if delayed until early 2023 after midterms, might be retroactive to the beginning of 2021. Retroactive application, however, is no guarantee even if a bill eventually passes. The continuing uncertainty means that prudent taxpayers should consider the ramifications as soon as possible if not already done.
If allowed to remain in place, the TCJA provisions may impede R&E programs going forward. Under the new mandatory capitalization rules, amortization of R&E expenditures begins from the midpoint of the taxable year in which the expenses are paid or incurred, resulting in a negative year one tax and cash flow impact when compared to the previous rules that allowed an immediate deduction.
The statutory language in TCJA indicates that while the amendment to section 174 is to be treated as a change in method of accounting, the new rule applies on a cut-off basis, meaning that any costs incurred in years before 2022 will remain as-is, with the capitalization requirement applying prospectively to costs incurred going forward. Taxpayers that previously expensed R&E expenditures lack guidance on whether they will need to file an Application for Change in Method of Accounting (Form 3115) to begin capitalizing and amortizing these expenditures.
In May of this year, the American Institute of CPAs (AICPA) Tax Executive Committee submitted comments to the Department of the Treasury and the IRS regarding the tax treatment of R&E expenditures under the TCJA. The AICPA comment letter recommends that the Treasury and IRS issue regulations providing that section 174(a)expenditures include direct costs, including employee compensation, contract labor, and materials, and, at the taxpayer’s election, allocable indirect and overhead costs. The AICPA also recommended that the IRS clarify the limitations on costs that are treated as R&E expenditures under existing IRS guidance which deals with costs of computer software.
We expect the IRS to release guidance specifically addressing how taxpayers must comply with the new rule for the 2022 tax year, presuming the effective date of the provision is not delayed by Congress. If you may have R&E expenditures during 2022, and want to more clearly understand the implications for you and your business, please contact your BMSS tax professional at (833) CPA-BMSS. We will continue to monitor releases from the IRS, the Treasury and possible legislation and keep you informed.