Key Details: The Tax Cuts and Jobs Act (TCJA) was passed in 2017 and made several significant changes to the way businesses account for deductions, depreciation, tax credits, and other tax-related items. One particular provision that sunset was the ability to expense research & experimental (R&E) costs the year they were incurred. This will be of particular interest to government contracting businesses as R&E expenses are often a significant portion of total expenses.
As provisions continue to change or sunset, businesses and taxpayers are encouraged to plan ahead and determine how these changes will impact their 2022 taxes, financial statements, accounting methods, and growth planning strategies. For further information and expertise, contact Ryan & Wetmore today.
What Changed for R&E Expenses?
Taxpayers are now required to capitalize and amortize R&E expenses for tax years that begin after December 31, 2021. This applies to R&E expenses paid or incurred in connection with the trade or business. Additionally, U.S.-based R&E expenses are to be capitalized and amortized over a five-year period while non-U.S.-based R&E expenses are to be capitalized and amortized over a fifteen-year period. Businesses should note that software development costs must be included in R&E expenses under Internal Revenue Code (IRC) Section 174(c)(3).
How were R&E Expenses Treated Prior to this?
Prior to the change caused by the TCJA, businesses had the following choices when accounting for R&E expenses:
- Deduct expenses immediately by adopting a tax method of accounting under IRC §174(a)
- Capitalize and amortize expenses over a minimum of 60 months under §174(b).
- Charge expenses to a capital account under Treasury Regulation §1.174-1.
Businesses should note that Congress failed to repeal the new mandatory capitalization rules in 2022 despite bipartisan support for postponing this change under Section 174. This means that businesses should start the proper preparations to address the impact of capitalizing R&E expenses on their 2022 tax return. However, legislation could still be introduced to repeal the amortization requirements under Section 174. Businesses are encouraged to stay tuned for any changes.
Identification and Tracking of Section 174 R&E Costs
Government contractors with R&E activities are encouraged to begin internal assessments to determine what steps are necessary to ensure their accounting system can adequately track and allocate R&E expenses. Proper identification, tracking, and allocation of covered Section 174 costs will be key in remaining compliant and competitive.
It is important to note that many government contractors may be able to leverage existing financial reporting systems to identify R&E expenses. Specifically, businesses currently capturing qualified research expenses (QREs) under IRC Section 41 for the R&D tax credit can utilize this as a starting point for R&E tracking and capitalization compliance. Aside from QREs identified for the R&D tax credit, government contractors are encouraged to track additional R&E costs such as:
- Gross wages / salaries.
- Facility costs such as heat and power.
- Depreciation expenses that are attributable to an R&E project.
- Models and drawings.
Furthermore, the TCJA included an amendment to Section 41 to better align with Section 174. As such, for research expenses to qualify as a QRE under Section 41, they must first be treated as Section 174 capitalized costs.
Businesses are encouraged to develop a process to adequately identify and track Section 174 expenses and to implement the appropriate internal controls to remain compliant.
Tax Implications and Timing Considerations
This rule requires the amortization of R&E expenses to begin from the midpoint of the taxable year in which expenses are paid or incurred. Furthermore, as these costs can no longer be deducted in the current tax year, the required capitalization will create a timing difference that will impact cash flow and funding or investing activities. Businesses should note that if an R&E project is abandoned prior to completion, the taxpayer is required to capitalize and amortize these expenses over the specified five- or fifteen-year period.
Furthermore, once taxpayers have identified and accurately tracked both the Section 174 expenses and the related amortization, analysis regarding necessary book/tax adjustments may be necessary. Businesses may continue to expense Section 174 costs as incurred for book purposes which may result in a difference in the total cost basis between depreciation recorded for financial reporting versus for tax reporting.
Conclusion and Next Steps
This mandatory capitalization of R&E expenses rule under Section 174 may materially impact your business. As such, taxpayers are encouraged to take the following actions to stay ahead:
- Analyze your current accounting system and determine if additional steps are required to set up a process where R&E expenses are accurately identified and tracked.
- Fully understand what costs are considered R&E.
- Develop internal policies and procedures and internal controls to ensure all R&E expenses are accounted for.
- Conduct an internal assessment of the potential impact this rule will have on your company’s cash flow and future taxes.
- Meet with your advisor to discuss the impact on your business tax planning. Some businesses may want to file extensions. If so, businesses should pay the tax now to avoid penalties.
- Update your accounting system to capitalize and amortize expenses.
- Analyze the impact this mandatory capitalization will have on your R&D tax credit.
- Conduct additional reconciliations between depreciation recorded for financial reporting versus tax reporting.
- Stay tuned as this regulation may be retroactively changed or updated.
Businesses are encouraged to meet with their trusted advisors to determine how this mandatory capitalization rule will impact future cash flow planning, state tax conformity issues, and accounting methods. For further information and expertise, contact Ryan & Wetmore today.
Today’s Thought Leaders
About Peter Ryan
Partner, Co-founder, & CPA
Peter T. Ryan co-founded Ryan & Wetmore in 1988 with business partner Michael J. Wetmore. Peter provides clients with the best strategies for success. His expertise extends across various industries. Peter obtained a Master of Business Administration in Finance from the University of Baltimore and a Bachelor of Arts in Accounting from the Catholic University of America.
About Jason Dudas
Partner & CPA
Jason is a Partner in our Vienna, VA office. Since joining the firm in 2009, he has worked closely with clients on tax, audit and accounting issues. Jason has become an expert in construction accounting and is a member of the Real Estate and Construction CPA’s. He also has experience with research and development credits, and tangible property regulations.
About Rosie Cheng
Finance Consultant
Rosie Cheng is a Finance Consultant at Ryan & Wetmore. She focuses on government contracting services and produces many of the firm’s government contracting newsletters. Rosie graduated from Georgetown University with a Master of Science in Management and from William and Mary with a Bachelor of Business Administration.