CPAs have long helped clients leverage the research and development tax credit to help drive both innovation and working capital with their businesses. However, significant changes are on the horizon for research and development expenses. As a result, CPAs across multiple industries need to evaluate their client approach to ensure their partners understand how to best utilize the updated tax laws to their benefit.
Understanding the potential changes can help you best advise your clients as they navigate possible shifts within the R&D tax credit terrain.
2022 Brings New Updates to the R&D Tax Credit
The current updates to the treatment of research and development expenses first began in 2017 as a provision in the Tax Cuts and Jobs Act (TCJA) — but didn’t officially go into effect until after December 31, 2021. Previously, all qualifying research and development expenses could be expensed under 26 U.S. Code § 174 - Research and experimental expenditures, which states:
“A taxpayer may treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account. The expenditures so treated shall be allowed as a deduction.”
However, under the current TCJA changes, businesses can no longer immediately deduct research and development expenses in the same year they’re incurred. Instead, the updated laws mandate that all qualifying research and development costs, including software development, must now be amortized over 60 months.
What the Current Changes Can Mean for Your Corporate Clients
What does capitalization mean for your corporate clients accustomed to tapping into what was once a dollar-for-dollar tax credit? Under Code 162 (ordinary and necessary business expenses), CPAs could still expense their clients’ R&D expenses as the general cost of doing business. But, shifting the designation on items previously categorized as R&D to a general expense can significantly impact your clients’ bottom lines.
For example, assume a software development company is operating with $5 million in revenue, $2 million in qualified R&D expenses, $500,000 of taxable income, and $185,000 of income tax. Under the previous R&D tax laws, the $2 million of qualified R&D expenses would be expensed, and a $158K federal tax credit would be generated to offset most of the $185K federal tax (assuming a flow-through entity and a 37% individual tax rate).
Now, under the current 2022 legislation, the same company would have to capitalize $1.6 million of their R&D costs, expense $400K, and would now have taxable income of $2.1 million and a tax bill of $777,000. They would still have a federal tax credit of $158,000, but their net tax after credits just jumped by $619,000.
Beyond impacting individual business, R&D capitalization can also have far-reaching consequences to U.S. innovation as a whole. Evolving requirements and shifts in policies can convolute the already existing process, making it more difficult than ever for American businesses to remain technologically competitive on a global scale.
New Research and Development Legislation May Still Change
There is some good news for taxpayers. This latest change to require capitalization of R&D expenses may soon be reversed or delayed. Congress recognizes the negative impact the new laws could have on small and large businesses alike — and they’ve sprung into action with the Build Back Better Act.
The Build Back Better Act currently has a specific provision for the R&D expense capitalization. According to recent reports by taxfoundation.org, Congress hopes to “Delay the requirement to amortize research and development (R&D) expenses over five years, instead of taking immediate deductions, to begin after 2025 instead of after 2021.”
The delay could prove invaluable to companies that have consistently claimed the deduction to ensure they can continue business as usual for at least the next three years.
R&D Tax Credit: The Time to Act Is Now
At Acena Consulting, we understand that raising awareness with our CPA partners about research and development expenses and capitalization is only a first step; the best way to make meaningful change is to encourage your clients to contact their local congressperson directly before their taxable income jumps by 80%. Contact Acena Consulting today for more information on how to help your clients navigate recent updates to the R&D tax credit law.