Starting in tax year 2022, R&D expenses must be amortized over a period of five years instead of deducting the expenses in the year incurred. Any foreign R&D expenses must be amortized over a period of 15 years. The requirement to amortize expenses is independent of the ability to claim the R&D tax credit. You CANNOT legally avoid the amortization requirement by refusing to claim the R&D tax credit.
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Why are R&D Expenses Amortized Now?
The Tax Cuts and Jobs Act (“TCJA”) passed in 2017 lowered business and individual tax rates. However, to keep the cost of the bill down, the writers of the bill included a provision beginning in tax year 2022 where all Internal Revenue Code Section 174 R&D expenditures in the United States must be amortized over a period of 5 years (foreign research must be amortized over a period of 15 years), regardless of whether the business claims the Section 41 R&D tax credit or not.
It’s crucial to note that while claiming the Section 41 R&D Tax Credit is optional, amortizing Section 174 expenses (all expenses qualifying for the Section 41 R&D Tax Credit are considered to be Section 174 expenses) is mandatory.
How Exactly Does This Change Work?
Before 2022, when a business claimed an R&D credit, all the Section 41 and 174 expenses could be deducted in the year in which the expenses were incurred. Now, those domestic qualified research expenses need to be amortized over a period of 5 years, starting with the midpoint of the taxable year in which the expense is paid or incurred. For a company with stable domestic R&D expenses, after 5 years of amortizing R&D expenses, the company will be back to its normal level of R&D deductions.
Because of the new amortization rules, the R&D tax credit has become even more of a necessity than ever. Consider a C-corporation with an annual tax credit of $40,000 and $600,000 in domestic R&D expenses every year. See the table below to illustrate the effects of amortization with and without the R&D tax credit.
|Tax Year||Credit||R&D Expenses||Increase in Taxable Income||Tax Rate||Additional Tax Without the R&D Credit||Net Increase in Tax with the R&D Credit|
It’s important to understand that a business can still receive a deduction for its R&D expenses. However, the tax deductions will be spread over a period of 5 years (15 for foreign R&D expenses).
We are confident that the amortization of R&D expenses will be repealed because both political parties have been in favor of restoring expensing, and a few bills have been introduced in the past year to further expand the R&D credit. Until then, the R&D tax credit is still one of the best benefits in the Internal Revenue Code to reduce tax burden.
Please reach out to us at TaxRobot if you have any questions or need any R&D planning advice.