The R&D tax credit is a 20% credit for incremental expenses incurred in domestic research and development activities. This credit benefits various businesses, but the vast majority of R&D claims at the federal level are from manufacturing businesses. However, virtually any industry can take advantage of the credit.
The Tax Cuts and Jobs Act of 2017 lowered business and individual tax rates and was favorable for companies claiming the R&D credit. The TCJA kept the R&D tax credit permanent, yet eliminated most other corporate tax credits and incentives for lower tax rates.
Before the TCJA, taxpayers had the option of expensing R&D expenditures immediately or electing to treat the expenditures as deferred expenses and amortizing the costs over a period of not less than 60 months, beginning with the month that the business first realized benefits from those expenditures. This generous treatment allowed taxpayers to utilize the current year’s deductions or defer them. Businesses were also given the option to amortize over 10 years certain expenditures that otherwise were deductible.
Then came 2022, which was a big year of change for the R&D credit. A shift in the treatment of certain deductions in the TCJA took place after Dec. 31, 2021. In essence, the TCJA, beginning in 2022, eliminated the taxpayer option to deduct current R&D expenditures. This means that taxpayers are now required to charge these expenditures to a capital account and amortize them over five years.
This change includes the extended amortization even in situations of a retired, abandoned or disposed-of property for which research expenses were paid or incurred — which means immediate deductions in those circumstances are denied now.
In addition, the new rules impact taxpayers’ expensing of software development costs or amortization of the costs over three years. The new rule says that any amount paid or incurred regarding the development of software shall be treated as a research or experimental expenditure, forcing it into a five-year amortization period.
What do the R&D updates mean?
This change in the treatment of R&D Section 174 expenses requires taxpayers to change accounting methods on a cut-off basis, without IRC Section 481(a) adjustment. The adjustment is a one-time catch-up adjustment allowed in the current year for missed deductions due to a recomputed calculation of depreciation or repair deductions.
Companies could deduct 100% of their R&D spending from their taxable income right away up until this year. With the change requiring companies to gradually write off expenses over five years taking effect in 2022, many businesses can expect to pay higher taxes.
In fact, according to the Joint Committee on Taxation, it will cost companies $29 billion by the end of September.
New legislation on the horizon
On Dec. 23, 2021, the Research and Development Tax Credit Expansion Act of 2021 was introduced in the House of Representatives. This bill attempts to modify the refundable research tax credit for new and small businesses in three ways:
- By increasing the limit on refundability to $500,000, with an adjustment for inflation.
- By allowing refundable amounts to cover all payroll taxes such businesses pay.
- By extending eligibility for the credit to small businesses with less than $10 million in gross receipts (was less than $5 million).
The bill would also increase the alternative simplified tax credit rate for such businesses. In short, the bill was written to amend the Tax Code of 1986 to expand refundability and increase the simplification of the research credit for certain small businesses.
However, with the Build Back Better Act stalled, these potential changes have not been made yet. It is also not yet known when or if these changes will be made.
Concerning the deductibility of the R&D expenses in 2022, certain US senators are attempting to expand the R&D credit to ensure businesses can fully deduct their R&D investments each year. A proposed bill can defer all the 2022 changes until after 2026.
In the meantime, for further reading, you can see the memorandum that was released providing guidance to the IRS on what constitutes acceptable documentation when filing R&D Credit refund claims. In connection with this, the IRS released FAQs and guidance to assist taxpayers in understanding how to respond to the new requirements.
Approaching the R&D Credit
Generally, taxpayers claiming the R&D credit are required to reduce their deduction for wages by the amount of the credit — not the amount of wages used in calculating the credit. This also requires that the taxpayer attach a statement to the return detailing what items have been reduced.
Under Sec. 280C(c), however, the taxpayer can elect to reduce the amount of the credit instead. The reduction is effectively equal to the amount of tax that would have been paid at the corporate rate had the taxpayer reduced deductible expenses. The election eliminates the need for the statement of reductions.
While R&D credits exist in about 37 states, in nearly all states the credit is limited to activities performed and expenses incurred in the state. It should also be noted that states vary significantly in methodologies — some allow for multiple calculation options; others do not. Most states do conform to one or more of the calculation methods of IRC Sec. 41.
Outside consultants are not necessary to claim the credit. However, in the case of an audit, the credit is likely to garner attention. Unfortunately, there are no specific recordkeeping requirements in the Tax Code or regulations for the credit.
For this reason, setting up good recordkeeping, accounting systems, and processes that are likely to pass muster on audits is important. Taxpayers are subject only to the standard recordkeeping requirements to maintain records sufficient to establish entitlement to the credit and the proper amounts.