2022 Changes to the Tax Treatment of R&D Costs
August 9, 2022
2022 Changes to the Tax Treatment of Research and Development Costs
As a result of a 2017 federal tax law, tax treatment of research and development costs was scheduled to change - beginning with the 2022 tax year. However, there is currently talk of tax legislation to modify or eliminate the effect of this 2017 tax provision.
The following is a summary of research and development expenses in general, the pre-2022 federal tax treatment, and the changes scheduled to take effect in 2022.
What are Research and Development Expenses?
Research and Development (R&D) expenses, also known as Section 174 research and experimentation (R&E) expenses, are costs incurred when a business is trying to create or improve a product. These costs include trying to obtain necessary information to eliminate the uncertainty that exists in the creation or improvement of a product or its design - whether they result in a product that is sold or used in one’s business. Once the uncertainty ends, and the new or improved product has been developed, then R&D expenses end.
Examples of products created may include:
Prior to 2022, businesses had numerous options for how to treat their R&D expenses for federal income tax purposes. The most common practice was to deduct the expenses immediately in the year they were incurred. If the business chose not to deduct expenses in the first year, then it must have received permission from the IRS to deduct the expenses later. Once the election to deduct expenses was made, then it could not be changed without IRS approval.
Another option was to amortize the expenses over a period of at least 60 months. The amortization period would begin with the first month that the business received an economic benefit from the costs. The election was limited to R&D expenses that were paid or incurred before 2022, that were not treated as currently deductible expenses, and that were chargeable to a capital account that was not property subject to an allowance for depreciation or depletion.
Another alternative was the write-off method. In this scenario, a business wrote off or deducted a percentage of the R&D expenses over a 10-year period, or 120 months. The period began with the tax year in which expenses were paid or incurred. With this method, the business did not have to receive an economic benefit from the R&D costs to take the deduction.
2022 Changes
The 2017 Tax Cuts and Jobs Act (TCJA) contained a provision that effective January 1, 2022, costs incurred for R&D activities would no longer be allowed for immediate deduction. Instead, current law stipulates that costs associated with R&D activities will have to be capitalized and amortized over 5 or 15 years. Costs related to R&D activities performed domestically will be recovered over a 5-year amortization period, whereas costs related to activities performed outside the US will be recovered over a 15-year period. The amortization period will begin with the midpoint of the taxable year in which the expenses were paid or incurred.
In addition to a tax deduction for R&D expenses, a tax credit is available. Businesses will file IRS Form 6765 to claim the credit. About Form 6765, Credit for Increasing Research Activities | Internal Revenue Service (irs.gov) If a company’s activities qualify for the R&D tax credit, there are two ways to calculate it.
Congressional Action to Change 2022 Rules
There is strong bipartisan support against the Section 174 amortization requirement created by the TCJA. Congress is currently considering a fix that would restore full expensing of R&D costs. Legislative proposals have been introduced to modify the application of Sec. 174. For example, a recent draft of the Build Back Better Act (BBBA) contained a provision that would defer the effective date from 2022 to 2026; however, BBBA has stalled in the Senate.
Final Thoughts
We will continue to monitor possible tax legislation that may undo the TCJA changes to the federal tax treatment of research and development expenses. However, considering the likelihood that there may not be a legislative fix in 2022, taxpayers that may be affected by these changes should consider this as part of their 2022 tax planning.
Please contact your Herbein + Company, Inc. tax consultant if you have questions regarding this article or need assistance with your 2022 tax planning.
As a result of a 2017 federal tax law, tax treatment of research and development costs was scheduled to change - beginning with the 2022 tax year. However, there is currently talk of tax legislation to modify or eliminate the effect of this 2017 tax provision.
The following is a summary of research and development expenses in general, the pre-2022 federal tax treatment, and the changes scheduled to take effect in 2022.
What are Research and Development Expenses?
Research and Development (R&D) expenses, also known as Section 174 research and experimentation (R&E) expenses, are costs incurred when a business is trying to create or improve a product. These costs include trying to obtain necessary information to eliminate the uncertainty that exists in the creation or improvement of a product or its design - whether they result in a product that is sold or used in one’s business. Once the uncertainty ends, and the new or improved product has been developed, then R&D expenses end.
Examples of products created may include:
- Formulas, processes, and techniques
- Inventions
- Models and tools
- Software
- Salaries paid in the production of research and development
- Supplies and materials used while in process of researching and developing a new product or design
- Costs in obtaining a patent from the US Patent & Trademark Office
- Attorney’s fees paid in conjunction with filing a patent application
- Hiring an outside contractor such as an engineering firm or research institute to perform research and development on one’s behalf
- Long-term assets like equipment, machinery, or real estate
- Production costs such as advertising or marketing of products, quality control testing, consumer surveys, and management or efficiency studies
- Research for literary, historical, or similar projects
- Acquiring a patent, production, or process from someone else
Prior to 2022, businesses had numerous options for how to treat their R&D expenses for federal income tax purposes. The most common practice was to deduct the expenses immediately in the year they were incurred. If the business chose not to deduct expenses in the first year, then it must have received permission from the IRS to deduct the expenses later. Once the election to deduct expenses was made, then it could not be changed without IRS approval.
Another option was to amortize the expenses over a period of at least 60 months. The amortization period would begin with the first month that the business received an economic benefit from the costs. The election was limited to R&D expenses that were paid or incurred before 2022, that were not treated as currently deductible expenses, and that were chargeable to a capital account that was not property subject to an allowance for depreciation or depletion.
Another alternative was the write-off method. In this scenario, a business wrote off or deducted a percentage of the R&D expenses over a 10-year period, or 120 months. The period began with the tax year in which expenses were paid or incurred. With this method, the business did not have to receive an economic benefit from the R&D costs to take the deduction.
2022 Changes
The 2017 Tax Cuts and Jobs Act (TCJA) contained a provision that effective January 1, 2022, costs incurred for R&D activities would no longer be allowed for immediate deduction. Instead, current law stipulates that costs associated with R&D activities will have to be capitalized and amortized over 5 or 15 years. Costs related to R&D activities performed domestically will be recovered over a 5-year amortization period, whereas costs related to activities performed outside the US will be recovered over a 15-year period. The amortization period will begin with the midpoint of the taxable year in which the expenses were paid or incurred.
In addition to a tax deduction for R&D expenses, a tax credit is available. Businesses will file IRS Form 6765 to claim the credit. About Form 6765, Credit for Increasing Research Activities | Internal Revenue Service (irs.gov) If a company’s activities qualify for the R&D tax credit, there are two ways to calculate it.
- Traditional Method - Under the traditional method, which is a complex calculation, the credit is 20% of the current year qualified research expenses (QRE) over a base amount. The base amount is a product of a fixed-base percentage and the company’s annual gross receipts of the prior four tax years. Businesses that have not claimed the R&D credit in the past or do not have historical data will likely have an easier time using the other method.
- Alternative Simplified Credit Method (ASC) - The ASC method involves a 4-step process. First, determine the average QREs for the past three years. Second, multiply that average by 50%. Third, subtract the result from step 2 from the current year QREs. Fourth, multiply step 3 by 14%. This will result in the amount of the R&D tax credit.
If the company had no research expenses in the previous three years, then the credit is 6% of the QREs for the current year.
Congressional Action to Change 2022 Rules
There is strong bipartisan support against the Section 174 amortization requirement created by the TCJA. Congress is currently considering a fix that would restore full expensing of R&D costs. Legislative proposals have been introduced to modify the application of Sec. 174. For example, a recent draft of the Build Back Better Act (BBBA) contained a provision that would defer the effective date from 2022 to 2026; however, BBBA has stalled in the Senate.
Final Thoughts
We will continue to monitor possible tax legislation that may undo the TCJA changes to the federal tax treatment of research and development expenses. However, considering the likelihood that there may not be a legislative fix in 2022, taxpayers that may be affected by these changes should consider this as part of their 2022 tax planning.
Please contact your Herbein + Company, Inc. tax consultant if you have questions regarding this article or need assistance with your 2022 tax planning.
Article Contributed by Jodi L. Lovell, EA, ATA.
