Since 1954 business owners have had the option to deduct certain expenses in the year that they incurred them. This was a critical way many offset the costs of researching and developing new products; it drove innovation in many industries.
But, as of now, the rules have changed. Effective January 1, 2022, IRC Section 174 now works a little differently in how you can deduct certain expenses. Some costs are now subject to required amortization.
Let’s take a look at what these changes are, how they may affect you, and how you can make the most out of your R&D amortization tax situation.
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Previously, research and development costs could be deducted immediately in the year they were paid or accrued. In addition, businesses could choose to amortize the costs over either five or ten years. This deduction was made possible through Section 174.
The Tax Cuts and Job Act of 2023 changed this. Businesses are now required to amortize R&D costs now, with no option to immediately deduct them. Domestic costs must be spread over five years, while foreign costs must be amortized over 15 years.
Expenses that are eligible to be deducted include:
- Administrative and overhead expenses
- Direct research and experimentation costs
- Costs of obtaining patents
Relation to the Section 41 Credit
It’s important to clarify that the Section 174 deduction and its related amortization requirement remain distinct from the Section 41 credit. This credit remains the same as in the past and rewards qualifying research in the U.S.
It includes a more narrow range of research and experimentation costs. They need to be direct costs such as:
- Employee payroll
- Expenses for outside contract expenses
However, there may be an overlap between expenses under the Section 41 credit and the Section 174 deduction. You have two options when this happens. You can either make a reduced credit election with Section 280C or add all Section 41 credit expenses to your tax return. Deciding which option is best may necessitate consultation with a tax advisor.
Most importantly, if you have expenses that qualify for the Section 41 credit, the rules require you to amortize those expenses REGARDLESS if you take the Section 41 credit.
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Elimination of Form 3115 Requirement
The IRS has tried to make it easier for businesses to comply with the Section 174 change by eliminating the Form 3115 requirement.
Instead of filing the form for Application for Change in Accounting Method, the change allows for filing a statement with the original federal return for the first year when Section 174 is effective.
If taxpayers make a change in their accounting method after the first tax year when the changes are effective, they cannot use this simplified approach. Instead, they must file Form 3115 in the next taxable year.
Effects on Individual Businesses
Taxpayers who previously miscategorized costs will almost certainly be affected. Some businesses put research and experimentation costs under Section 162, which is for ordinary and necessary business expenses.
To prevent future issues, business owners need to make sure they are correctly categorizing costs and should therefore assess their current categorizations.
Businesses that would usually immediately deduct costs will face an increase in their taxable income. They would need to take this into account during tax planning and when making quarterly estimated tax payments.
Multi-national businesses will see an increase in deferred tax assets subject to assessment for realizability. They may need to pay attention to quarterly and annual tax calculations for accounting purposes. An increase in taxable income could also affect other international and federal tax provisions.
Unfortunately, some experts worry the change will harm small businesses and startups. R&D deductions will be less valuable, and claiming them will be more complicated. Some are worried that businesses may engage in research and development less frequently.
Others say that amortization may lead to reduced economic growth because it penalizes investment in industries that heavily rely on R&D. Some policy critics go so far as to say it violates neutrality. They argue it’s a penalty that disproportionately hurts high-tech industries that policies are usually targeted to help because they increase long-term economic growth.
Manufacturers do most R&D, accounting for 58% in the private sector. 22.4% comes from the information industry, which includes software and data processing. Professional, scientific, and technical services can account for another 10.8%. If the change to forced amortization were canceled, experts estimate the above three industries might see a 20% reduction in tax liability for 2023.
Because of concerns like these, other bills were introduced to halt the change. This included H.R. 1304, the American Innovation and R&D Competitiveness Act. This would have allowed for immediate expensing of R&D costs. Another Senate would have also maintained immediate expensing while doubling refundable credits for startups and expanding eligibility. As you might have guessed, these attempts were unsuccessful.
How to Make the Most of Your R&D Tax Situation
Many small businesses have difficulty knowing what tax credits and deductions are available to them. This is especially complicated when many are temporary, as during the changes that have occurred during the pandemic. To fight this, business owners need to stay familiar with how R&D expenses, among others, are treated.
You should also complete tax planning to ensure you take full advantage and maximize your savings. Consulting an expert can help you set up a plan, so you’re not surprised at tax time.
It’s also best to use an expert when filing your returns so you can claim all of the credits and deductions you are eligible for. By using TaxRobot, you can do this in three easy steps. Plus, we answer questions and requests if you’re ever audited and offer value-based pricing.
Getting the most out of your tax situation doesn’t have to be overwhelming or expensive.
Ensure You Understand the 2022 R&D Tax Amortization Changes
As of January 1, 2022, businesses may not immediately deduct R&D expenses. Instead, you must amortize them over either five or 15 years, depending on the nature of the costs.
While this may not be an optimal situation, you do have ways to make the best of it. Make sure you work with a tax professional who can steer you in the right direction for tax planning and help you claim all the credits and deductions you’re eligible for.
Want to make getting your tax credit refunds easy? Contact us so we can get started helping you!