Research and development (R&D) tax breaks are a set of tax incentives intended to attract firms with high research expenditures to the United States. They’ve existed for going on 70 years, but the Tax Cuts and Jobs Act (TCJA) in 2017 changed how they can be expensed.
Namely, starting in tax year 2022, R&D expenditures can no longer be expensed in the first year of service, and instead those expenses will need to be amortized over five years in the case of domestic research, and 15 years for foreign research. This is known as “capitalizing” those expenses. This capitalization or amortization requirement can be especially onerous on startups, which may incur the bulk of their R&D costs in their first year of operation. This may make it difficult for startups to recoup those losses in their first year and cause them to wait for the equivalent of a lifetime in startup years.
R&D costs include all costs incidental to research and experimentation in connection with a trade or business, such as pursuing a new patent registration and associated cost, materials, drawings and salaries. In sum, R&D expenses can make up a large portion of a startup’s overhead.
At the risk of sounding trite: Call your lawmakers.
Earlier this year, there were signs of bipartisan support for a repeal of the requirement and a return to first-year expensing, but soaring inflation may have put a damper on those initiatives. The perception is that the R&D tax breaks chiefly benefit large corporations, and the political picture of issuing huge tax cuts to corporations like Intel and Lockheed Martin may prove a bridge too far for lawmakers. Tax year 2022 is flying by, several high-profile bills have come and gone, and there are no eminent signs of a repeal in the works.
Preparing to amortize R&D expenses
If Congress repeals the amortization requirement, well and good. But all the same, there are some things we can do now to prepare for the possibility of the rule coming into effect.
First, retain a tax professional if you haven’t already. If that is your CFO, great; if not, start talking to a tax attorney now — avoid one-click shops that promise to get you your credits, as they won’t be there when you get audited. If the law remains unchanged, starting in March, estimated tax payments will have to be made without the first-year R&D deductions and reflecting amortization.
The IRS has already named improper claiming of the R&D tax credit (not the expensing of R&D costs but the related credit) as one of its “Dirty Dozen” tax scams, so it will be looking at returns. Tax scammers don’t wear signs, and they market themselves as looking out for your best interests and aiding in getting you the credits you deserve. Work with a reputable tax attorney and save yourself the headache.
Second, and more generally, perform a cost-benefit analysis when purchasing things like software rather than developing them in-house. The depreciation rules for software, for example, also require depreciation over time, but they may provide a tighter timeline for recouping expenses. A tax professional will be able to assist you, but generally, the analysis revolves around looking at the economic life of the product to be purchased or developed: the longer the economic life of the product, as in the case of a patent, the more it may remain profitable to develop in-house rather than purchase.
Third, firms subject to the new R&D amortization requirement will need to begin tracking research costs in order to amortize them. For many startups, R&D costs were treated with a broad expense brush, but now startups will need to ensure they are being closely monitored and substantiated for purposes of capitalization.
Fourth, examine the interplay between expensing your R&D costs and the related R&D tax credit, which is targeted at direct research expenses. You may want to explore the benefits of taking a lower R&D tax credit in order to prevent a reduction in future R&D expensing, but a tax professional will be able to speak to your individual financial situation.
Finally, if you’ve never taken the R&D deduction because you either don’t believe you qualify or fear an audit, learn about it and see if you qualify. The relevant regulations promulgated under code section 174 define research or experimental expenditures rather broadly, including “expenses incurred in a trade or business which represent costs in the experimental or laboratory sense” that are “incident to the development or improvement of a product.”
Such “products” include everything from pilot models and formulas, to techniques, patents, processes and inventions. If you haven’t taken the deduction before, the loss of the first year expensing option will be less of a hit to your cash flow.
Can anything be done?
At the risk of sounding trite: Call your lawmakers.
The perception among advocates for keeping the law the way it is — with an amortization requirement — is that the issue is solely a “Big Tech” problem. Some faceless leviathan tech company is complaining that they can’t write off their R&D in the first year of service and have to wait to see tax savings. Even proponents of repealing the amortization requirement speak chiefly about the benefit to large corporations trickling down to their employees.
Startups are not a part of the conversation. That needs to change if the bill is to be repealed. “Small businesses” poll much higher than large corporations, and a politically involved startup community might be what is required here.