The Tax Cuts and Jobs Acts (TCJA) of 2017 included amendments to IRC §174 beginning in 2022, such that companies that invest in Research and Development (R&D) can no longer claim a current deduction for these expenses. Instead, these companies are required to amortize their research and development costs over a five-year period, starting with the midpoint of the taxable year in which the expense is paid or incurred.
Background on Research and Development Activities and Credits
Businesses, especially startup businesses, must complete research and development activities in order to proceed with development and application of new technologies. The R&D tax credit has been available to taxpayers since 1981 to encourage businesses to carry on research and development activities by allowing both a deduction and credit for qualified research and development expenditures. The amendments to IRC §174 could deter companies from starting these activities, or require them to obtain additional funding to cover the added costs.
The amendments to IRC §174 did not impact how taxpayers can qualify for the R&D credit or how the credit is computed. To alleviate some of the tax burden and administrative reporting relative to the amendments to IRC §174, taxpayers can now claim the full R&D credit rather than a reduced credit to avoid adjustments that were previously required under IRC §280C.
Impact of the Amendments to Businesses
Minimal guidance provided by the IRS relative to the §174 changes left many tax professionals and taxpayers unsure of how to move forward with research and development expenses for the 2022 tax year and beyond. Despite overwhelming support for efforts to repeal or delay the changes to IRC §174, there has been little movement in response to these concerns. As a result, companies that were forced to file their 2022 tax returns including these changes experienced significant impacts to their taxable income. If these taxpayers and their professional tax advisors were not cognizant of these changes, they likely faced unexpected tax bills when they filed their tax returns this year.
To put the impact into perspective, let us look at an example. A startup company developing new technology will typically end their tax year with a net loss, resulting in no tax bill. However, with these IRC §174 changes, the year-end situation is very different.
- The startup company expects to end their 2022 tax year with a $500,000 net loss. Included in this net loss is $1 million in research and development expenses.
- Under the old rules, the company was able to fully deduct the $1 million in research and development expenses, which sustained their net tax loss, resulting in no taxes due.
- However, under the new rules, the $1 million of research and development expenses are not currently deductible. Instead, they must amortize the $1 million in research and development expenses starting with the midpoint of the taxable year, meaning only $100,000 of the $1 million is currently deductible.
- The $900,000 research and development expense add-back results in taxable income of $400,000, rather than a $500,000 net loss.
- Assuming the startup is a C Corporation, taxed at 21%, this is an $84,000 tax liability that would not have otherwise been incurred under the old rules.
In addition to the repercussions felt at the Federal level, the impacts at the State level were all over the board. Some states conformed to the Federal changes, other States did not conform, and some States were unclear. These inconsistencies further complicated the impact of the changes. For example, in Pennsylvania, the IRC §174 changes apply to Corporate Net Income Tax but not to Personal Income Tax, meaning that pass-through entities can fully deduct research and development expenses, but corporations cannot. (see related post on PTEs) Making the situation even more complex is the fact that that Pennsylvania has its own R&D credit separate from the Federal R&D credit. (see related post about the PA R&D credit)
These issues create confusion and frustration for businesses and their tax advisors, who have been given very little guidance. Fortunately, there may be light at the end of the tunnel as the IRS recently released some additional information related to the IRC §174 amendments.
Guidance from the IRS
On September 8, 2023, the IRS issued Notice 2023-63, providing interim guidance to clarify the application of IRC §174 and announcing that the agency intends to issue proposed regulations consistent with the interim guidance. The Notice addresses many issues including definitions used in the TCJA amendments to IRC §174, the treatment of software development, short taxable years, research performed under contract, and the disposition of R&D property. The IRS is requesting comments to be submitted on the interim guidance until November 24, 2023.
Until final regulations are issued, taxpayers should continue to comply with IRC §174 as outlined in the TCJA and Notice 2023-63. GYF will continue to monitor and communicate any updates. Please do not hesitate to contact your GYF Tax Executive at 412-338-9300 if you have any questions or concerns related to tax credits or other issues.
Alyssa Lucas assisted with the research and writing of this article and has published several other blog posts on a variety of topics. She joined the GYF Tax Group in 2023, following her graduation from Robert Morris University. Alyssa provides tax compliance and planning services to individuals and businesses.
