In 2017. The United States Government (USG) passed the Tax Cuts and Jobs Act which dramatically changed the tax laws in the US. One section of the act, Section 174, went into effect in 2022. This section requires Companies to capitalize their “Research and Experimental” (R&E) expenditures and amortize them over 5 years using a half-year convention in year one if incurred in the U.S. or 15 years for costs incurred outside the U.S . This rule also applies to all software development costs, including software developed for sale or license to customers and software developed for internal use.
The question for Contractors is, what qualifies as a research and experimental expense. Several examples in the rule include costs such as salaries of researchers, overhead expenses used for R&D, supplies used during the research process, and certain software development costs. But is it simply the Independent Research and Development (IR&D) that is currently expensed compliant with Cost Accounting Standard 420 or does it include any funded research and development performed under contract with the Federal Government? Unfortunately, the answer is unclear. The Internal Revenue Service and the Treasury Department have said they will issue further guidance, but nothing has been published yet. There has also been talk in Congress to delay or remove this mandatory capitalization requirement, but again, nothing yet.
What guidance should we be giving our clients?
Our clients need to do two things now:
1) Make sure their projects and/or general ledgers are arranged in a way that allows for easy identification of both funded and independent R&D costs.
Many of our clients are already tracking IR&D to properly classify the costs in compliance with CAS420 and report it appropriately on their annual incurred cost submission. Other organizations may be capturing IR&D expenditures to properly report the costs under ASC 730 guidance or be calculating qualifying research expenditures for purposes of the research tax credit.
The new rule stipulated that expenditures eligible for the R&D credit are required to be amortized under Section 174. Accordingly, taxpayers computing an R&D credit study can use their credit calculation as a starting point for capturing R&E costs. However, Section 174 includes more types of expenses than those that qualify for the R&D credit, such as:
- Activities related to patent departments,
- Foreign-based research activities, and
- Overhead or other indirect costs, such as depreciation and utilities.
Organizations that do not already track these costs need to create separate projects or accounts to properly segregate all of their research and experimental costs. In addition, they need to ensure any research and experimental costs incurred under existing contracts are easily identified and segregated at the project level from non-R&E costs.
2) Prepare for the impact on their tax liability
As the amortization of the R&E expenses will impact taxable income, any
items impacted by a change in taxable income should be considered as well. In certain instances, there could be an impact on a taxpayer’s effective tax rate to the extent that a permanent provision is impacted by this rule.
Corporations reporting financials under ASC 740 must consider the impact the R&E rule may have on their tax provision calculations. This new rule will likely create a deferred tax asset that needs to be taken into consideration. Other companies may see an increase in tax liability due to the reduction in deduction of current year R&E.
To have a conversation about the impact on your organizations, reach out to the consulting professional at Saggar & Rosenberg.