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Changes to Research and Development (R&D) Expense Tax Treatment

Research and development (R&D) is a very important part of the current US and international business climate, and certain tax incentives associated with these expenses are crucial to give innovators the tools and encouragement to conduct research and development.

What are Research & Experimental expenses?

Some companies will incur research and experimental expenditures in the normal course of business. From a tax perspective, research and experimental expenditures are defined as expenditures incurred in connection with a taxpayer’s trade or business which represents research and development costs in the experimental or laboratory sense. These costs are also associated with the development and improvement of a product, the acquisition of patents, and the associated attorneys’ fees to make and perfect a patent application. These are also defined as activities intended to discover information that would help to eliminate uncertainty concerning product development or improvement endeavors. 

What are Research & Development expenses?

Research and development expenses are any expenses associated directly with the research and development of a company’s goods or services and any intellectual property generated in the process. These are also defined as direct expenditures relating to a company’s efforts to develop, design, and enhance its products, services, technologies, or processes – any and all expenses which contribute directly to the process of finding and creating new products or services. Research and development expenses can also include quality control measures through which a business evaluates a product to ensure that it is still adequate and discuss improvements that could be made to the current product or in future models.

What was the previous treatment of Research & Experimental Expenses?

The previous treatment of research and experimental expenses prior to 2021 was that taxpayers that incur research and experimental expenditures in its trade or business during the tax year may elect to do any of the following: expense them immediately in the year paid or incurred, amortize and deduct them over a period of at least 60 months beginning with the month the taxpayer first realized benefits from the expenditures, or amortize and deduct them ratably over a period of 10 years under Code Sec. 59(e) for alternative minimum tax purposes beginning with the tax year in which the expenses are paid or incurred. 

What is the new treatment of Research & Experimental expenses?

Unlike in previous years, for tax years beginning after 2021 research & experimental expenditures paid or incurred during the tax year must be amortized and deducted over a five-year period (or 15 years if foreign-sourced). This change was made by the Tax Cuts and Jobs Act which eliminated the previous option for taxpayers to expense costs and deduct them immediately. Due to the treatment required in Section 174,  some taxpayers’ tax obligations have tripled which threatens the existence of many firms big and small.

What are the areas of uncertainty?

With the new rule, a lot of uncertainty arises. One uncertainty is the impact that it may have on the cash flow statement. Since taxpayers can no longer deduct research & experimental expenditures, any taxpayer previously relying on them for tax planning will likely face an increase in estimated tax payments needed to cover additional federal and state tax liabilities. Another uncertainty arises with the tax accounting method. Taxpayers have been required to file an automatic accounting method change to change from directly expensing to capitalizing research & experimental costs, but currently, there is no law on how the new method needs to be implemented. There is also uncertainty about how Research & Development credits will be handled. As the criteria is outlined in IRC Section 41, qualified research expenses must meet the definition of research & experimental expenditures under IRC Section 174. Taxpayers will also need to determine how capitalizing qualified research expenses will affect the research & development credit. Tax provision impact is also an area of uncertainty because the new Tax Cuts and Jobs Act provision creates a disparity between the timing of deductions for research & experimental costs for Generally Accepted Accounting Principles (GAAP) and the timing of deductions for income tax accounting purposes because taxpayers now must account for deferred tax assets attributable to capitalized research & experimental costs.

How does this impact estimated payments?

Under the new Tax Cuts and Jobs Act rule, 90% of a taxpayer’s current research & experimental expenditures are not currently deductible under a half-year convention in the year of the rule change. Therefore, the taxpayer’s taxable income for that year will increase, potentially requiring greater quarterly estimated tax payments. Assuming taxpayers did not account for this rule change when making quarterly payments due this year, the remaining payments for the year may have to be increased. 

Looking to the Future

As this regulation is receiving more speculation, there are talks about a new bill that will permanently allow for immediate research and development expensing. This is to be known as the American Innovation and R&D Competitiveness Act. Many Americans believe that research and development plays a crucial role in creating good-paying jobs across the country and to rebuild the economy from the impacts of the pandemic. Many people believe that if we do not allow for the research and development tax deduction there will be numerous repercussions on jobs and the economy. Research and development is known to be one of the most powerful tax tools because it allows taxpayers to invest in the short term as well as sustain our investment toward long-term growth and innovation. 

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied upon for tax, legal, or accounting advice. If you have any questions about tax planning strategies, please do not hesitate to contact us at Lear & Pannepacker.