As part of the Tax Cuts and Jobs Act (TCJA), there was a change to Section 174 that directly impacts the R&D tax credit many startups take. Beginning after 12/31/2021, research and experimental expenditures need to be capitalized instead of expensed as previously allowed. In other words, you need to spread out your deduction over several years instead of taking it all at once.
There was some hope that Congress would step in and protect business owners from the Section 174 changes, but ultimately, nothing happened. As a result, this change affects your 2022 tax filings. And that means that founders need to be informed about the potentially significant impact.
Understanding Section 174
As amended by the TCJA, Section 174 now says that research or experimental expenditures come with an amortized deduction. If those capitalized expenses are for domestic research purposes, they need to be amortized over five years. If you conduct research overseas, you need to amortize the expenses over fifteen years.
This affects R&D expenditures including:
- Some software and technology expenses
- Payroll costs for researchers
- The cost of domestic and foreign R&D subcontractors
- Legal fees for original patents
In other words, this means big changes for companies that have significant research expenses — in particular, early-stage technology companies and companies in the manufacturing industry.
These notable Section 174 changes can directly impact:
- Taxable income
- The estimated taxes you owe in 2022
- Income tax provisions for financial statement purposes
More details to know
There are special rules under Section 174 that exclude Land and Exploration expenditures. The special rules also make note that expenditures related to software development, in particular, are considered research and experimental for purposes of Section 174.
You should be aware that the overall changes to Section 174 potentially impact your Qualified Small Business Stock taxes (Section 1202). Additionally, if you live in a state that imposes a Capital Base Tax (e.g., New York), this also impacts that base rate.
Finally, it’s important to note here that specified research or experimental expenditures mean, with respect to any taxable year, research or experimental expenditures which are paid or incurred by the taxpayer during that specific taxable year in connection with the taxpayer’s trade or business. Don’t confuse this with Section 195 Startup Expenses, which have a separate 15-year amortization period.
Avoiding a 2022 Accounting Method Change application
The IRS clarified in Rev Proc 2023-11 that you don’t need to file Form 3115 (the Accounting Method Change application) this year if your company files a statement with its 2022 tax return.
The statement needs to include all of the following:
- Your name and employer identification number or social security number (whichever applies)
- The beginning and end dates of the first taxable year in which the change to the required Section 174 method will take effect for your company
- The designated automatic accounting method change number for this change
- A description of the type of R&D expenditures
- The amount you paid or incurred for those specified R&D expenditures
- A declaration that you’re changing the method of accounting for the R&D expenditures to capitalize them to a specific R&D capital account and amortize the amount over the applicable time period
- A declaration that you’re making this change on a cut-off basis
Clearly, a lot needs to go into this statement. Our team of R&D tax credit experts can help you draft something that covers all of the bases.
Navigating these tax changes
In the past, many startups maximized what they defined as R&D in an effort to limit their tax liability. Moving forward, though, this tactic delivers less favorable outcomes because you’ll have to spread out those costs over time. It makes sense to pivot — or at least fine-tune — your R&D spending strategy.
We can help. Here at ShayCPA, our firm has a particular specialization in assisting early-stage technology companies. That means we work with companies that will be dramatically impacted by this change, like those that invest heavily in software development.
Under U.S. generally accepted accounting principles (GAAP), software development costs are typically expensed as incurred instead of capitalized. The changes to Section 174 (as they currently stand) would create significant Book to Tax differences. For smaller companies without internal finance resources, they will also create a record-keeping burden that may require additional time tracking and allocation schedules to be in compliance under audit.
That’s where we come in. Not only can our experts help you adapt your R&D spending strategy to better align with the new Section 174 changes, but we can also help you navigate what it means for your 2022 tax filings.
For help wrapping your head around this potentially major change, preparing your 2022 taxes to be in compliance, and adjusting your accounting methods moving forward, we’re here. Contact our team of R&D tax credit experts at ShayCPA today.