To incentivize investing in research and development, companies may be eligible for tax credits or a tax deduction for qualifying expenses. But what is the difference? Below we dive into the differences between Research & Development (R&D) tax credits and deducting R&D expenses, and how the new amortization requirement that started in 2022 affects both.
Key Takeaways:
- Research & Development tax credits will remain the same outside of extensions added through the Inflation Reduction Act of 2022 (IRA)
- Under current law, Research & Development expenses incurred beginning after December 31, 2021, will need to be capitalized and amortized over a five-year period for R&D activities executed domestically
- R&D expenses incurred outside of the United States will require a 15-year amortization period
- There is an increasing possibility that Congress could extend the rule that allows for current year expensing of R&D instead of capitalizing and amortizing, but we currently recommend businesses operate under the assumption that the amortization requirement will not be repealed
Difference Between R&D Tax Credit and R&D Deduction
R&D Expense Deduction Defined
Money that is paid for research and development expenditures is an R&D expense. This could include expenses paid to develop new items like a new application, a new process, etc. The expense is deducted on the current year tax return, just like any other tax business expense.
R&D Tax Credit Defined
The R&D tax credit, sometimes referred to as the Research & Experimentation tax credit, is an additional benefit on top of the tax expense, but the qualifications for the R&D tax credit are stricter than the expense deduction. This means some R&D tax expenses may not qualify for the R&D tax credit. There are different methods to calculate the tax credit, but some methods allow you to elect a reduced tax credit, which then allows you to still claim the full expense. This gives you the benefits of a current year expense and then allows you to claim an additional tax credit on top of these expenses.
Changes to the Treatment of R&D Expenses
So, what is the change you have been hearing about in the news as of late? The change relates directly to the R&D expense deduction. Back in 2017, when the Tax Cuts and Jobs Act (TCJA) came out, it included a provision that required taxpayers to capitalize and amortize R&D expenses starting after December 31, 2021, rather than currently deducting them.
This change does not affect the calculation of the current year tax credit. This means, starting in 2022, taxpayers could still claim the same tax credit related to R&D as they have done in the past, but they will no longer be able to deduct those expenses in the current year.
While expenses related to R&D activities are undergoing a shift in deductibility this year, the R&D tax credit will remain the same other than the expansion of the Inflation Reduction Act of 2022 (IRA). The IRA expanded the annual cap on the tax credit used to offset small businesses’ payroll tax liability from $250,000 to $500,000 for qualifying businesses.
How to Qualify for the R&D Tax Credit
In order to qualify for the tax credit, businesses had to continually manufacture, research or engineer new processes and products. Qualifying businesses may also include companies that design and develop product alternatives, create more efficient designs, or improve techniques, formulas, inventions or software. Outside of the 2022 expansion, there are no further changes to the qualifications of the tax credit.
New Amortization Requirements for R&D Deductions
As stated above, the treatment of research and development expenses has been drastically altered in 2022. The TCJA amended I.R.C. §174 so that beginning in 2022, firms investing in R&D must amortize those costs over five years. This process starts with the midpoint of the taxable year in which the expense was paid or incurred. If a company conducts research outside of the United States, the costs associated with that research must be amortized over 15 years.
Businesses were previously allowed to deduct those expenses immediately and, according to Bloomberg Tax, this will be the first time since 1954 that companies will have to amortize their costs instead. In addition to amortizing their R&D costs over five years, now companies must capitalize research costs, classifying them as an asset rather than an expense. These costs can include developing production systems, completing product studies, securing patents or hiring specialists.
How Companies Can Prepare for R&D Changes
Those businesses still holding out hope that Congress will repeal the amortization requirement may want to reconsider and begin making plans moving forward under the assumption that amortization is here to stay, at least for the 2022 tax year. If a company hasn’t made quarterly payments towards their research expenses, they could face a large tax liability come April. Failure to make quarterly payments may also subject these businesses to underpayment penalties.
Working with an experienced CPA to guide your business through these recent changes can help reveal previously untapped tax incentives and prepare you for any unexpected tax liabilities. Anders tax advisors are here to help. Contact an Anders advisor below to learn more.
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