General Overview & Estimated Payment Impact:
As of 1/1/2022, a key provision of the Tax Cuts and Jobs Act (TCJA) went into effect. Taxpayers are no longer able to deduct research and experimentation (R&E) expenses under Section 174. Previously, taxpayers had the option to deduct Section 174 expenses in the year they were incurred. However, due to the TCJA, taxpayers are no longer allowed to deduct these expenses and now must capitalize them over a period of five years for research conducted within the United States, or 15 years for research conducted outside of the United States.
Despite bipartisan support to reverse the TCJA changes to Sec. 174, the changes remain in effect. Therefore, to avoid an underpayment penalty, corporations and individuals not relying on a prior-year safe harbor must begin including the impact of Sec. 174 capitalization in estimated tax payments. The IRS may impose an underpayment penalty for each quarter that taxpayers remit estimated tax payments that are less than the amount that should have been paid.
What Tax Prepares Need to Know:
How to identify which taxpayers will be impacted by the Section 174 changes?
A good starting point is to identify all taxpayers who have claimed an R&D credit. Clients who have claimed a credit in the past are likely to continue to have R&E expenditures in 2022.
What if a client has never claimed an R&D Credit?
Do not assume this change only applies to businesses that claim an R&D credit. It’s important to note that Section 174 expenses and the R&D tax credit are not one in the same. All R&D credit expenses must qualify as a Section 174 expense, but not all Sec. 174 deductible expenses need to meet R&D credit Section 41 requirements. Businesses can have Sec. 174 expenses even if they do not claim R&D tax credits.
Taxpayers subject to Sect. 174 capitalization will be those performing activities that are technological in nature (software development, engineering, manufacturing, and/or also develop products, formulations, inventions, patents, and prototypes).
What are Section 174 Expenses?
Section 174 expenditures include all research or experimental expenditures paid or incurred in connection with the taxpayer’s trade or business. This includes all costs incident to the development or improvement of a product. Examples of Sec. 174 expenses include:
- Salaries, including overhead
- Patent costs, including attorney fees
- Utilities
- Depreciation
- Drawings
- Models
- Lab Materials
- Rental Costs
- Travel
- Software development expenses
- Foreign R&E
Accounting Method Change
Revenue Procedure 2023-11 provides guidance on how to adapt for the change in the 2022 tax year:
- General rule – Typically, accounting method changes require filing Form 3115. To simplify filing, taxpayers can adopt the new required capitalization of R&E expenditures by attaching a statement to their return for the 2022 tax year. Additional details about the contents of such a statement are outlined in the Revenue Procedure.
- Short-year returns – Tax returns for 2022 that are filed before Jan. 17, 2023 qualify for a special transition rule. Specifically, such taxpayers will be deemed to have complied with the Revenue Procedure as long as the R&E expenditures were properly reported on Form 4562, Part IV.
Recommended Next Steps:
Given the bipartisan and industry support, we believe that mandatory Section 174 capitalization will be repealed or delayed further down the road. However, we are uncertain when this would be passed by Congress. Given this, we feel taxpayers should extend their 2022 returns and should also account for Sec. 174 capitalization in preparing estimated payments.
To further discuss Section 174 capitalization, contact KPT today!
