Changes to the Tax Deductibility of R&D Costs: What You Need to Know

Prior to the TCJA, taxpayers could choose to either expense R&D costs immediately or gradually write off those costs (amortize them) over a period of at least 60 months. However, the TCJA will eliminate the option to immediately expense these costs under a new provision starting in 2022. 

This means that the IRS will no longer permit companies to deduct R&D expenses in the year they incurred them. Instead, they will require companies to charge those expenses to a capital account and amortize them over five or fifteen tax years—five if the company performed the R&D activities in the U.S. and fifteen if they served them internationally. 

To put it more succinctly, when a company can no longer deduct the full R&D cost in the year in which it incurred the cost, that company sees a reduction to the cash tax benefit of the R&D on a year-by-year basis. 

That’s bad news, especially for life sciences organizations with collaborative funding agreements between multiple developers or companies, who may now no longer be able to deduct expenses in a timely fashion that aligns with their generally accepted accounting practices (GAAP). 

Additionally, businesses that shut down R&D projects before completion will no longer be able to write off the remaining basis of the costs. Instead, they will need to amortize the costs of the abandoned projects.

The extended amortization period also applies to cases of retired, abandoned, or disposed property and taxpayers who use Revenue Procedure 2000-50 to expense software development costs or amortize them over 36 months. The latter group will have to amortize their expenses over five years, as well. 

What about R&D Tax Credits?

Since implementing R&D Tax Credits in 1981, companies who qualify to claim have reduced their tax liability by significant amounts. 

Eligibility for these credits is broad and includes companies who:

• Develop or design new products or processes.
• Enhance existing products or processes.
• Develop or improve upon existing prototypes and software.

The list of activities that constitute R&D for these credits is expansive. What’s more, businesses of all sizes can qualify—even startups. A special “Startup Provision” provides eligibility for companies with less than $5 million in gross receipts in a given credit year and have no more than five years of gross receipts in total. 

Good news: the TCJA left these tax credits in place. In fact, it even expanded them for certain taxpayers and made them permanent. 

That said, each company will have to look closely at how capitalizing R&D expenses will affect their eligibility, as they may discover the timing of their deductions has indirect negative consequences.

On the other hand, a closer examination of your R&D costs may lead you to discover new opportunities to claim additional R&D credits you weren’t aware of previously.

Why were these changes made?

Overall, the intent of the TCJA was to simplify the tax code and encourage economic development in the United States. However, many view the upcoming changes to R&D expensing to have the opposite result by raising the investment cost.  

So why were these changes included? 

Simple: they had to pay for the bill, and the R&D cost amortization requirement saved money. By partially offsetting the cost of the rest of the package, the elimination of immediate expensing helped the TCJA meet Senate budget rules. 

It’s worth mentioning that there is some bipartisan support in Congress for reversing this provision. In February of this year, legislation was introduced in the House which would modify this provision of the TCJA to allow immediate expensing again. As of August, nearly 80 members of Congress had signed to co-sponsor the bill, but it has yet to find its way to the floor of the House for a vote. 

Assuming the new requirements will go into effect on December 31st, your business should take steps to prepare.