R&E Expenditure changes (Section 174) and what it means for startups

TLDR;

• What was it? Section 174 of the Internal Revenue Code allowed taxpayers to deduct research and experimental expenses (R&E expenses) as business expenses rather than capitalizing and amortizing them over time.
  
  
• What are R&E expenditures? The term "experimental" is meant to be broad and generic, encompassing costs incurred for activities aimed at discovering information that would eliminate uncertainty about developing or improving a business component, such as software development. This includes products held for sale, lease, or license, as well as products used in the taxpayer's trade or business (Treas. Reg. Sec. 1.174-2(a)(1) and (3)).
  
  
• What changed? Taxpayers must capitalize and amortize all R&E expenditures, including software development, beginning in 2022. Costs for R&E activities conducted in the United States or abroad must be amortized over 5 or 15 years, respectively, using a midyear convention.
  
  
• The impact: Reduced deductions and increased taxable income will have an impact on both startups and large corporations in the form of increased taxable income. Continue reading for example.
  
  
• Action needed: Consider how this new law will affect your tax and financial reporting positions. Startups should consider how this change will impact their cash flow, R&D credits, loss on abandoned projects, foreign tax issues, state & local tax, etc.
  
  
• What does the future hold? Section 174 capitalization of research and experimental costs may be here to stay, as Congress failed to reach an agreement on a legislative fix despite widespread bipartisan support. 
  Here’s where you can help us raise our voice in our letter to Congress to repeal the law that impacts all startups.

We sent a letter to 8 House and Senate representatives on March 08. 2023. You can help us gain momentum by signing this petition on Change.Org here. 

Here is the letter sent by the AICPA to Congress on February 14, 2023 and their detailed blog. 

Let's dive into the details... 

What was it?

Historically, Section 174 allowed taxpayers to deduct R&E expenses in the year they were incurred. Since the passage of Section 174 in 1954, companies large and small engaged in research-based activities have relied on full expensing as a significant cost recovery mechanism.

While Section 174 and the regulations do not provide an exhaustive list of costs incurred as a result of research, Treas. Reg. Sec. 1.174-4(c) gives taxpayers an example in which the following expenses are treated as Section 174:

• Salaries
• Heat, light, and power as part of the research and development
• Drawings or blueprints
• Pilots and models
• Laboratory materials
• Attorneys’ fees, and
• Depreciation on build attributable to the R&E project

What changed?

Section 174 was significantly altered by the Tax Cuts and Jobs Act of 2017 (TCJA), which took effect for taxable years beginning in 2022. Currently, the ability to deduct R&E expenses has been completely eliminated by the change. Instead, beginning with the tax year 2022, taxpayers must capitalize and amortize these costs.

The TCJA added software development to Section 174's definition of R&E expenditures. As part of the law change, Congress mandated that any internal or external software development be treated as section 174 expenditures, requiring capitalization under section 174.

Taxpayers must capitalize and amortize all R&E expenditures beginning in 2022. Costs for domestic R&E activities must be amortized over 5 years, while costs for international R&E activities must be amortized over 15 years, using a half-year convention.

The impact: Smaller deductions and higher taxable income will have an impact on both startups and large corporations. Every taxpayer who spends money on R&E is affected by the law change. There are no exceptions to the capitalization requirement in Section 174. Whether a company invests $10,000 or $100 million in R&E, the costs must be capitalized.

Certain industries will undoubtedly suffer far more than others. Companies in technology, manufacturing, and bioscience, for example, will see significant increases in taxable income beginning in 2022.

Consider the following basic taxpayer example (assuming all R&E costs are incurred in the United States):

A startup generates $600,000 per year in Total income. Every year, the company incurs $300,000 in non-R&D operating expenses. In 2022, the company hires developers to create new software and incurs $400,000 in qualifying R&D expenses. The $400,000 in R&D costs must be capitalized and amortized over 5 years using the half-year convention for the 2022 tax year. Due to convention rules, the full cost is only recoverable in the sixth year.

As shown above, without R&D capitalization, the startup would have a tax loss and not have to pay income taxes for the year. Assuming nothing changes, the company would report taxable income of $260,000, necessitating a sizable tax payment to the IRS and the states under the new law, depending on state tax laws.

Action required:

Consider how this new law will affect your tax and financial reporting positions. Startups should consider how this change will affect their cash flow, project losses, R&D credits, foreign tax issues, state and local tax, etc.

Startups at all stages should consider the following steps and work with their tax professional to improve tax planning and cash flow management.

• Examine their R&D activities and expenses to determine which are R&E and which are operating expenses.
• Maintain detailed records of all R&D expenses, including contract research costs, to ensure compliance with the new rules.
• Consult with a tax professional to ensure that you understand the new rules and take advantage of all available deductions.
• Consider the impact of Section 174 changes on their R&D strategy and budget, and make necessary adjustments to ensure that they can continue to pursue innovative activities.

What does the future hold?

Despite strong support in Congress for repealing the Section 174 law change, as well as a vocal lobbying effort from industry groups, Congress was unable to address this pressing issue. Worse still, the new divided Congress appears to be in no hurry to address tax issues.

Because Congress could not reach an agreement on a legislative fix, capitalization of research and experimental costs under Section 174 may be here to stay. However, we remain optimistic that this will be repealed or that Congress will find a workaround for smaller businesses. 

The IRS recently released procedural guidance for tax professionals, eliminating the need to file form 3115 for accounting changes. However, we are still waiting on technical guidance from the IRS. 

We're proceeding as if these changes are permanent as of March 2023. Please consult with a tax professional to ensure you plan for taxes. By making our voices heard in Congress, you can make a difference. Please help us get the most signatures on the letter to Congress here.

If your startup is unsure of how to navigate these changes, Arbo can help.