The Tax Cuts and Jobs Act (TCJA) passed in 2017 was primarily effective beginning in 2018 with the exception of section 174 Research and Experimental (R&E) expenditures. Many legislative proposals were made to delay or repeal the required amortization of these expenses; however, Congress failed to act prior to the end of 2022.
Who is impacted:
• Businesses that perform research activity, or
• Businesses that claim the research credit under IRC Section 41 (R&D Tax Credit), or
• Anyone with software development costs, regardless of internal or external use.
What is R&E:
• IRC Section 174 – All activities and costs incident to the elimination of uncertainty concerning the development or improvement of a product, process, software, technique, formula, or invention that is held for sale, lease, or license, or used in the taxpayer’s trade or business.
- Note: IRC Section 41 qualified expenses (those eligible for the Research and Development Credit) are included within the definition of 174. The issue of concern is that section 174 is quite broad and includes additional items.
- For example: Section 41 credit eligible expenses include direct research, support, and supervision (wages, supplies, contract research, and computer lease costs). Section 174 includes those plus foreign research, funded research, reverse engineering, indirect support, and supervision; may include an allocable portion of overhead costs such as rent and utilities, depreciation on build attributable to the R&E project, cost recovery, patent fees, foreign research costs, attorneys’ fees; and ALL software development costs.
PREVIOUSLY: For R&E expenses, options existed to 1) currently expense in the year incurred under 174(a), 2) capitalize and amortize costs over 60 months under 174(b), or 3) elect under 59(e) to amortize over 10 years. For software development costs, options existed to currently expense, amortize over 36 months, or amortize over 60 months. For many businesses, the option to deduct the entire amount in the year incurred was utilized to accelerate expenses and defer tax.
CURRENT: Effective January 1, 2022 with the delayed effective date for the TCJA section 174 expenditures, all R&E costs must be amortized over a period of 5 or 15 years depending upon whether it is attributable to foreign research. Software development costs are specifically included in the definition of R&E costs and are subject to mandatory amortization. Additionally, the taxpayer cannot recover R&E costs before the end of the amortization period even if sold or abandoned, and the taxpayer is limited to a half-year amortization in year 1.
If you are concerned this change in tax law will impact you, please reach out to your point of contact at Seidel Schroeder so that we can discuss identification of expenses, the tax impact, and options to minimize the impact.