The change enacted under the Tax Cut and Jobs Act (TCJA) to require capitalization of qualified research and development expenses penalizes small businesses much more than publicly traded corporations. This penalty is so severe that it threatens to undermine the ability of small businesses to remain viable and competitive in a rapidly changing and global marketplace.
IRS Code Section 174 First Launched to Eliminate Uncertainty with R&D Expenditures
IRS Code Section 174 Amortization of research and experimental expenditures (Section 174) was enacted in 1954 to eliminate uncertainty in tax and accounting treatment of research and experimental development (R&E), commonly referred to now as research and development (R&D), expenditures and to encourage research and developmental experimentation as a means to grow innovation.
Section 174 allowed businesses to either deduct or amortize certain research and development costs. Deductions can be made in the year in which they are paid or incurred, or they can be amortized over a period of not less than 60 months (international R&D costs must be amortized not less than 180 months), beginning with the month in which the taxpayer first realizes benefits from the expenditures.
Understanding TCJA Changes
As part of the TCJA, signed into law by President Trump in 2017, the same expenses incurred for research and development activities, as of 1/1/2022, must be capitalized and amortized over 60 months.
The Impact of Capitalizing R&D Expenditures
The catastrophic impact of capitalizing R&D expenditures on businesses cannot be understated. Money spent to develop and innovate always poses risks to the business owner. The requirement to capitalize R&D expenditures effectively taxes the money spent on innovation. While the expense is amortized over 60 months, the negative impact on cash flow and growth is immediate.
To illustrate the prohibitive cost of this innovation penalty on a business spending money to develop new software applications:
Facts: ABC Company ("ABC") develops new software applications for the consumer market. As a small business, ABC generates $1.5 million in revenue annually and has a taxable income of $300,000. As with most software development companies, a substantial portion of the company's operating expenses are the wages paid to developers and software engineers who develop the architecture and applications. For this example, assume salaries make up $850,000 of the operating expenses, or 57% of the revenue. We will assume $750,000 of the salaries are for development, and the remaining salaries are for sales or other functions.
Other development expenses include cloud space (for developing and testing new software applications) and contracted software coders. Cloud development space expenses totaled $15,000, and outside coding expenses totaled $80,000. Total direct development costs under this example would total $845,000.
In addition to these expenses, Section 174 requires that payments incurred "in connection with" the R&D activities must be included in the total Section 174 expenses to be capitalized. Under current IRS guidance, other expenses to be included are payroll taxes, benefits, rent, utilities, and other ancillary expenses. For this example, we will assume that 15% of the direct expenses for the additional payroll taxes, benefits, and other expenses must be included. Section 174 expenses under this example would total $971,750 ($845,000 x 115%).
Capitalizing the R&D Expenditures
Under the new capitalization requirements, the business must capitalize the Section 174 expenses and amortize them over 60 months. In the initial year, the amortization is determined using a half-year convention, meaning only half of a full year's amortization is allowed (10% rather than a full-year 20% of the total expenses capitalized).
Returning to our illustration, ABC had gross receipts of $1,500,000 and taxable income of $300,000 before the requirement to capitalize R&D expenditures under Section 174. The result of this accounting change is to increase taxable income by $874,575 ($971,750 - $97,175 - year one amortization).
ABC's taxable income is now $1,174,575 ($300,000 + 874,575).
Remember that from a cash flow perspective, ABC has already paid $971,575 for these expenses and will now pay the tax on $1,174,575. The amount of tax due will now vary depending on whether ABC is organized as a pass-through entity or C-Corporation.
The Small Business Innovation Penalty
Most small businesses like ABC are organized as pass-through entities. This means the entity does not pay federal income tax; the income or loss from the business (as well as credits and other tax items) passes through the entity to the company's owners. The tax is paid at the shareholder or partner (individual) level rather than at the corporate level. Pass-through entities are typically organized as S Corporations, LLCs (Limited Liability Corporations), or partnerships.
Publicly traded companies cannot be organized as pass-through entities and instead pay a corporate-level tax as a C corporation.
The top individual tax rate in 2023 is 37%, while the top corporate tax rate for a C Corporation is 21%.
The tax due from ABC as a pass-through entity would be significant. With the capitalization of the R&D expenses, taxable income would rise to $1,174,575 (Original Taxable Income of $300,000 + $971,575 of capitalized expenses - $97,175 first-year amortization). The tax due would be $434,592 ($1,174,575 x 37%). As a reminder, ABC's cash outlay for operating expenses is $1,200,000 ($1,500,000 revenue less $300,000 net income). When adding in the tax due from the capitalization of R&D expenses, the total cash required for operations and taxes becomes $1,634,592, resulting in a negative cash flow of $134,592.
If ABC is a C Corporation, the tax due would be $246,660 ($1,174,575 x 21%). The total cash outlay for operations and taxes for ABC as a C Corporation would be $1,446,660, resulting in a positive cash flow of $53,340.
In either case, the risk of conducting research and development activities results in an unsustainable business model.
The Credit for Increasing Research and Development Activities
Under Internal Revenue Code Section 41 Credit for increasing research activities ("Section 41"), qualifying R&D activities generate a federal tax credit to reduce the tax due by the company conducting the activities. These are typically the same activities that result in the capitalized expenses discussed above under Code Section 174.
To illustrate how the R&D tax credit impacts overall tax due and cash flow for ABC:
The direct R&D expenditures totaled $845,000 (wages, computer rental expenses, and contract research expenses). Please note that under Section 41, only direct expenses can be included in the tax credit calculation formula. Expenditures "in connection with" are not included in the calculation. In addition, contract research expenses are limited to 65% of the amount spent. So, in our example, ABC spent $80,000 for contract software coders (we will assume they are based in the U.S.). In calculating the federal R&D tax credit, we would only include $52,000 ($80,000 x 65%) for contract research, bringing our direct expenditures for qualified R&D activities down to $817,000 ($845,000 minus $80,000 plus $52,000). The R&D tax credit would be calculated in our example to be $81,700 (the credit is a 20% credit but is limited to 50% of the qualified expenses).
As a pass-through entity, ABC's additional tax due to capitalization was $434,592. Subtracting the R&D credit of $81,700 would bring the taxes due down to $352,892. The total cash required (after taking into account the R&D tax credit) would be $1,552,892 ($1,200,000 operating expenses plus $352,892), resulting in a negative cash flow of $52,592.
As a C Corporation, ABC's additional tax due to capitalization was $246,660. Subtracting the R&D credit of $81,700 would bring the taxes due down to $164,960. The total cash required (after taking into account the R&D tax credit) would be $1,364,960 ($1,200,000 plus $164,960), resulting in a positive cash flow of $135,040.
The impact of the federal R&D tax credit does not mitigate the damage.
The Capitalization of R&D Expenditures Is Not a Timing Difference
One of the factors proponents lean on when discussing the impact of R&D expenditure capitalization is that the business will recoup the expenses over 60 months. As we have discussed, the initial year of expenditure results in only 10% of the expenditures being amortized into taxable income. This means the negative impact is spread over six years rather than five years. Additionally, if the business continues to grow its revenue (which would be expected), the expenses related to R&D activities would also grow. While the incremental amount capitalized would decrease (each year would include 20% of the prior year as amortization, reducing the overall amount capitalized), the amount capitalized on the balance sheet would continue to increase rather than decrease over time.
The business would not "catch up" until they halted R&D activities, assuming they grew at greater than 10% yearly. This creates a no-win scenario for businesses to spend capital to improve, innovate, or develop new products, software, techniques, formulas, or inventions. Congress has made it impossible for U.S. businesses to compete globally.
Understanding the Impact on Your Business
Concerned about how changes to R&D expense treatment under the Tax Cuts and Jobs Act (TCJA) can significantly affect your business? Acena Consulting can help. Schedule a time to connect with one of our research and development tax credit experts today.
