The biggest tax law change to become effective for the 2022 tax year requires Research and Experimentation Expenses, also referred to as R&E expenses, to be capitalized over a five year period for US activities, and over a 15-year period for work performed outside the US. This means that expenses paid last year for these activities cannot be fully deducted in the current year, and the deductions will only be able to offset income for many future years to come. This is a massive departure from how these expenditures were treated previously, and will have ripple effects for small and large businesses, and the US economy.
What are R&E Expenses?
The Research and Experimentation (R&E) law, as written, is very broad, and basically, any amounts spent on research and development activities must now be capitalized, not deducted, against your tax return. Without further guidance from the IRS, basically, any kind of a business or management study could be considered research for R&E purposes, including development of physical products. Plus, a section was specifically added to the law to categorize all software development as R&E expenses to be capitalized.
What are some examples of Research expenses for R&E capitalization purposes?
Research is very vaguely defined in the law as written, so many management studies that are commonly done in businesses will now fall under R&E. If your business performs a feasibility study, work for a proof of concept, or even market research to find product market fit possibilities, these expenditures will be now categorized for R&E capitalization. A number of common marketing expenses will also be R&E expenses under the current law, such as a demographic study or even an SEO keyword search!
What are some examples of Experimentation expenses for R&E capitalization purposes?
Experimentation includes all development costs, including things like re-tooling equipment, designing new products, or retrofitting existing products. It is currently unclear if activities such as engineering new building components will fall under R&E, and it seems likely that this very vague law will encompass that. There are some specific mentions to depreciable and depletable expenses in the law, which seems to imply that many costs related to physical production and mineral exploration would clearly be included as expenditures under Section 174.
What types of software development must be capitalized?
Section 174 very clearly outlined that all expenses related to R&E software development must be capitalized as well, even for small changes made to existing or off-the-shelf products. It has been argued that an IT department writing a single line of code could be considered R&E expenses. Many types of software development that are not R&D creditworthy, such as improvements made to an existing product, incremental releases, and internal use software, are all still included as R&E for capitalization.
What expenses should be included as R&E expenses?
The law is very broad, and it has been posited that all expenses of a company should be allocated to the portion of activities that are R&E, even overhead expenses. If this holds, it would mean even things like office expenses and legal costs for the companies should be allocated to the R&E activities.
Furthermore, the law hints that depreciation amounts must be included in the allocation for R&E. This is a little head-scratching considering that depreciation is already deducted over a number of years. For example, let’s say you have a machine worth $1,000,000 that you placed in service in 2021, and it has been depreciating for over 15 years.
With MACRS, you would be entitled to deduct $95,000 for 2022 against your current income. But if this machine was used for US R&E activities, then the depreciation is added to the R&E capitalization, and only $9,500 can be deducted for 2022. Convoluted? Yes. But tax law is rarely logical, and this is an extreme example of that lack of logic hurting businesses.
What is the difference between R&D and R&E Expenses?
Qualifying expenses for the Research and Development (R&D) credit, and expenses for the Research and Experimentation (R&E) capitalization requirements are very different. What is allowed for R&D credits is extremely restrictive, especially for software development where a four-part test must be met in order to take advantage of the credit. However, in the R&E rules software development activities were included under a blanket regulation. Thus, even if you don’t qualify for R&D credits, your software development activities are R&E expenses and need to be capitalized.
Are R&D credits more valuable now because of the R&E capitalization rules?
Some R&D credit companies are trying to make this claim, but claiming R&D credits is riskier than ever due questionable and inflated promises by unscrupulous providers whose pricing is based on a percentage. In the future, R&D Credits will likely be a highly audited area.
Recent tax court cases and IRS memos have outlined that in order to qualify for a R&D credit, a company must now do full due diligence prior to filing the tax return. This is a very time consuming process for founders, generally it takes at least 20 hours to organize the due diligence documents for a very simple R&D credit report. Thus, the amount of the credit must outweigh not only the costs of time and money associated with filing, but also the risk of litigation.
When did the R&E Expenses Change Happen?
The changes to Section 174 were written in during the Tax Cuts and Jobs Act (TCJA) as a budget-balancing provision, but nobody in the accounting profession expected these rules to become effective. Section 174 was expected to be repealed in January, but the bi-partisan provision did not pass. Thus, for tax years beginning on or after December 31, 2021 (meaning all 2022 tax returns), these provisions now will apply, and all expenses that are considered R&E expenses must be capitalized instead of deducted.
Is there an IRS form to report R&E Section 174?
Section 174 taxes are reported on standard depreciation forms such as Form 4562. The change in Section 174 requires R&E expenses to be capitalized and amortized over a period of five years for US-based research, or 15 years for non-US-based research. This method begins at the midpoint of the tax year (2022), in which the expenses are paid or incurred, which splits the accounting, meaning just 10% of expenses are able to be deducted for 2022 if US-based development, or a little over 3% of foreign-paid expenditures.
Has the IRS issued guidance about Section 174 R&E?
The IRS has only published guidance regarding the change in accounting method for §174. However, the IRS still has not provided clear guidance on the exact treatment of R&E expenses, which can have a huge impact on deductions, especially for software development companies. Currently, the rules are extremely broad, and it is uncertain if a transition period is possible or if further guidance will allow more favorable treatment in certain circumstances.
Do I have to capitalize salary payments related to R&E expenses and activities?
R&E expenses also include employee salaries or independent contractor payments for any type of research or development activities. It is currently unclear whether the entire salary of a person performing R&E activities must be capitalized, or if this can be allocated to various activities that employee performs, the way salaries are allocated to qualified activities when preparing R&D credits.
When development labor costs are amortized, this will have a negative impact on the bottom line, creating additional taxable income. For example, if there are $100,000 of software development costs, no longer a deduction but amortized over 5 years, only $120,000 can be deducted in the first year for US-based development, or $3,333 for non-US development activities.
How do I determine where R&E activities were performed?
This can be difficult these days with outsourcing and many companies hiring overseas developers. If you hire independent contractors for development work, it can be hard to know where in the world they are providing this from. Also, many employees with remote engagements are choosing to be digital nomads and work outside the US. The conservative position in many cases would be to capitalize over the 15-year period if you are uncertain where the work was actually performed.
Should I file an extension if I have a tax increase because of R&E?
Cleer is advising our clients who are negatively affected by these R&E expenses to hold their returns until the IRS provides clear guidelines on how these expenses should be treated or if the definition will be clarified or changed. This both minimizes risk and may benefit in additional tax savings as guidance develops. Submission of returns under current rules can result in amended returns, which because of the change in accounting method required, may not be allowed.
If there is a balance due on your estimated tax return, it is recommended that you pay the tax owed by the deadline for filing your return. This way, if any potential tax changes made are not in your favor, you will have minimized the risk of penalties and interest accruing. If you end up overpaying, then you can request a refund from the IRS when your tax return is filed.
If you have any questions about filing extensions due to R&E expenses, schedule a consultation with one of the experts at Cleer Tax to discuss it further. We also offer all-inclusive bookkeeping packages, which include your monthly statements plus your federal and state tax returns.
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