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

The Tax Cuts and Jobs Act (TCJA) of 2017 included changes to the tax-deductibility of Research and Development expenditures which will go into effect for tax years beginning after December 31st, 2021. 

Research and Development (R&D) is one of the most common costs associated with doing business, especially in the life sciences sector. So many businesses, including startups, will experience the effects of this change. 

For example, many businesses may experience substantial alterations to their cash flow, as well as their reporting on deferred taxes. 

The delayed effective date provides a window of opportunity for taxpayers to prepare to make the most of the situation. But with the end of the year fast approaching, now is the time to make sure you understand how the new requirements surrounding R&D expenses will impact your business in 2022 and beyond. 

This article will examine these changes to R&D expensing in more detail and provide guidance for the tax-planning strategies you should develop moving forward. 

How will R&D capitalization work in 2022?

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. 

How can I prepare for the R&D tax credit changes?

The last time United States companies could not immediately expense their aggregate R&D costs with other deductible expenses? 1954. As a result, most companies do not have the necessary accounting processes to identify and separate R&D expenditures. Your first step should be creating and implementing processes to do precisely that. 

Next, make sure that you have thorough and properly-prepared supporting documentation for any R&D tax credits. Documents you should prepare can include:

  • Ledger charts of account
  • Organizational charts
  • Accounting approach used
  • Wages paid
  • Supply expenses
  • Fixed based percentage calculations

Of course, there will be unique specifics to how your company will need to prepare, which may differ from other companies. Generally, however, there are some areas you should be sure to pay attention to.

For example, be sure to consider how forced amortization will impact your cash flow. Without the tax benefit provided by immediate R&D cost deductions, you will need cash available to cover your estimated federal and state tax liabilities. Remember that you may see your taxable income and net cash tax due increase by a significant amount. 

As previously mentioned, you may experience a timing gap between your amortized deductions and your GAAP cost deductions. Therefore, you should consider developing a plan to account for deferred tax assets that occur due to your R&D cost capitalization. 

Finally, you should consider the ramifications of any R&D you are conducting in a foreign jurisdiction. Remember, the amortization period is fifteen years for international R&D activities, but only five for activities conducted in the United States. So, although labor may be cheaper offshore, you may benefit from relocating to the U.S. In addition, moving foreign R&D stateside may create new eligibility for the R&D tax credit. Whether these benefits offset other expenses may depend upon your unique business. 

In closing...

Unless Congress intervenes, R&D capitalization is approaching—and fast. The new R&D expense requirements may be unpleasant to face, and the significance of these changes may be complex and challenging for your business.

But with the right plan in place on December 31st and with informed and intelligent guidance from trusted tax professionals, you can prepare to make the needed adjustments.

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Jeff Coyle, CPA

Jeff Coyle, CPA, Partner of Rosenberg Chesnov, has been with the firm since 2015. He joined the firm after 20 years of business and accounting experience where he learned the value of accurate reporting, using financial information as a basis for good business decisions and the importance of accounting for management.

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Prior to joining the firm in 2015, Jeff was in the private sector where he held senior financial and management positions including Controller and Chief Financial Officer. He has experience across industries, including construction, technology and professional services which gives him a deep understanding of business.

Jeff graduated from Montclair State University, he is a CPA and member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and New Jersey State Society of Public Accountants.

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Jody H. Chesnov, CPA, Managing Partner of Rosenberg Chesnov, has been with the firm since 2004.  After a career of public accounting and general management, Jody knows the value of good financials.  Clarity, decision making, and strategy all start with the facts – Jody has been revealing the facts and turning them into good business results for more than three decades.

He takes a pragmatic approach to accounting, finance and business. His work has supported many companies on their path to growth, including helping them find investors, manage scaling and overcome hurdles.  His experience and passion for business reach beyond accounting and he helps businesses focus on what the numbers mean organizationally, operationally and financially.

He has a particular expertise in early-stage growth companies.  His strengths lie in cutting through the noise to come up with useful, out of the box, solutions that support clients in building their businesses and realizing their larger visions.

Prior to joining the firm in 2004, Jody was in the private sector where he held senior financial and management positions including General Manager, Chief Financial Officer and Controller.  He has experience across industries, which gives him a deep understanding of business.

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