R&D Expenditure Capitalization Rules (New for 2022)
The TCJA amended Section 174 relating to the federal tax treatment of research or experimental expenditures paid or incurred during the taxable year. The new Section 174 rules require taxpayers to capitalize and amortize specified R&E expenditures over a period of five years (for costs attributable to domestic research), or 15 years (for costs attributable to foreign research), beginning with the midpoint of the taxable year in which the expenses are paid or incurred. Under new Section 174(c)(3), software development costs are treated as R&E expenditures and must also be capitalized and amortized in accordance with the new rules.
How does this impact your tech startup?
Technology Companies performing research and development (engineers, software engineers, etc.) will no longer be able to deduct 100% of their expenses starting in 2022 and for future year tax years. If your company receives the R&D Tax Credit, for example, this would mean that those costs will now be capitalized.
Founders and their finance teams will need to provide an analysis of their research and experimental expenses (Section 174 Costs) to accurately prepare corporate tax returns. Ultimately, determining what is and isn’t a Section 174 cost will be the responsibility of each company.
What is an IRC Section 174 expense?
An IRC Section 174 expense is one that’s directly connected to the taxpayer’s trade or business and represents an R&D cost in the experimental or laboratory sense. Examples include but are not limited to the following:
- Wages paid to employees who were directly involved in R&D activities and the individuals who directly supervised or supported their work
- Supplies and raw materials used in design, fabrication, or testing that were not capitalized or depreciated
- Work performed by a third party as part of a contract, in which the business assumed the brunt of the economic risk, regardless of the outcome
Will my company suddenly be subject to corporate taxes as a result of not being able to deduct 100% of my expenses for 2022?
There is potential for your tech company to owe taxes even if you had a financial statement loss for the year. Once the Section 174 analysis is provided – determination of tax liability, if any, will be incurred as a result.
What if I don’t have time to provide this analysis before the filing deadline of April 18th, 2023?
If you need more time to complete and prepare this analysis, your company can file a tax extension which gives you until Oct 17, 2023 to file the tax return. Any taxes due must be paid by April 18th, 2023, however.
How does this impact the R&D Tax Credit?
The Research & Experimentation Credit, commonly known as the R&D Tax Credit, falls under section 41 of the Internal Revenue Code. However, there is a lot of overlap and some significant differences between the two code sections (Section 41 and Section 174). By definition, any Section 41 costs are Section 174 costs; however, the same doesn’t apply vice-versa. The R&D Tax Credit in most years has been used to offset Payroll Taxes by Startups that generate Net Operating Losses. If your Startup has taxable income as a result of the changes, the R&D Tax Credit can be used first to offset any corporate income taxes, and the remainder can be used to offset payroll taxes if they qualify under the small business rules – Per the Protecting Americans from Tax Hikes (PATH) Act of 2015, if your gross receipts are less than $5 million and you’ve been in business for fewer than five years, you can most likely claim a credit of up to $250,000 to apply toward the social security tax on your payroll.
Does my company have to attach any additional documentation to our 2022 tax return?
Yes, a footnote disclosure needs to be attached to the tax return in lieu of filing a Form 3115 (Application for Change in Accounting Method) detailing the following:
- Name and Employer Identification Number of the company
- Beginning and Ending dates of the tax year of change
- Description of the automatic accounting method change number
- A statement detailing the type of expenditures included in the change
- Amount of R&E Expenditures paid or incurred during the year of the change.
Will the law change back to the way it was?
Taxpayers should continue to monitor the legislative process for potential changes to restore expensing under Section 174. While retroactive relief has not yet been enacted, negotiations are likely to continue into 2023. Taxpayers should be prepared to comply with and implement the new rules. The IRS has not released the substantive guidance on implementing the new Section 174 rules, but it is expected to do so soon.
With this being said, the taxpayer is responsible for identifying all R&D expenses and breaking these out between domestic and international expenses so that these can be reported using the new Section 174 capitalization rules effective 1/1/2022 if there is no change to the law.
How about if I get audited – what do I need to provide?
Under an audit, you will need to provide Payroll and Project documentation showing personnel involved in the various R&D projects the company undertook during the tax year.
Documents that show the project identifying and resolving uncertainties throughout the project lifecycle. This can include screenshots or photos of the product as it undergoes changes, emails, or code check-ins showing how testing occurred throughout the project, results of various tests of the product, iterations of specifications/PRDs, engineering design docs, post-mortem minutes, and presentations or other meeting notes.
Documents that describe the project and show that activities undertaken during the project either resolved or were intended to resolve technical uncertainty. Typical documentation could include project records, meeting notes, post-mortem reviews, design options considered, and comments on pull requests or other code check-ins.
SHAY CPA P.C. highly recommends that if you utilize GitHub, you maintain a yearly folder with copies of all GitHub records associated with the R&D Credit project.
See link from the IRS that contains additional information regarding section 174 expenditure.
Okay, what’s next?
Upon completion of the analysis of your research and experimental expenses (Section 174 Costs), adjustments will be made to present the financial statements on the tax return in accordance with the new rules.
Should you have any questions regarding these changes, just contact us! Our team will be more than happy to set up a meeting and talk things through.