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Changes in Research & Experimentation Costs - Capitalization and Amortization

By Donna Holm


Since 1954, businesses that incurred R&E expenses under IRC §174 have been able to deduct them as paid or accrued. Unfortunately, the Tax Cuts and Jobs Act (TCJA) of 2017 changed this for tax years starting in 2022. While we expected that R&D amortization would be done away with or at least delayed, the time has come to start planning.

The Build Back Better Act, which was passed in August 2022, contained language to push the R&E amortization out to 2026. Unfortunately those changes did not make it into the final bill and subsequent legislation through the end of the year did not address this issue. As a result, taxpayers currently taking advantage of R&D expense deductions could be hit with an increased tax liability.

The TCJA legislated that R&E costs, including software development costs, must be capitalized and then amortized over a period of 5 or 15 years for domestic and international costs, respectively.

Historically, taxpayers deducted the full amount of their non-capitalized R&E expenses in the year incurred. Starting in tax years beginning after 12/31/2021, this deduction will be spread out over a period of years. This reduces the value of the R&D expenses in the current tax year and can impact taxable income. For new start-ups, this will most likely reduce the amount of net operating losses which are generated. Note that net operating losses were already limited in 2021 to 80% of taxable income in future years of the carry forward.

Taxpayers who usually depend on R&E expense deductions may be hit with a surprise. They will only be able to write 1/5 of the amount of domestic expenses or 1/15 of expenses for global expense. In addition, because of the requirement to use the mid-year amortization convention, the company will only be allowed half of the deduction in the first year (the other half comes in year 6 or 16).

Coordination with the R&D Credit

Most expenses incurred for the R&D Credit under IRC §41 are also includable under §174, though the §174 R&D expense definitions are broader and include foreign R&D. While the company can no longer claim all of deduction for the §174 R&D expenses in the year incurred, they can still include any eligible expense for that year’s §41 R&E credit. While the deductions are applied to the revenue, the R&D credit is applied after taxes are calculated, resulting in dollar-for-dollar reduction in the tax owed. Any credits not used in the year generated can be carried forward indefinitely.

Method Change

On December 12, 2022, the IRS published Rev Proc 2023-8. The intent was to provide a temporary fix for the capitalization of §174 costs. This procedure provides guidance for implementing the accounting change needed to the new accounting method as it relates to §174 costs. The procedure modifies Rev Proc 2022-14 so that automatic consent is allowed. Form 3115 (Application for Change in Accounting Method) will not be required. Instead, a statement needs to be attached to the 2022 tax return. If the method change is made after this time, Form 3115 and a §481(a) adjustment will be required.

If you think you may be impacted by these changes to the R&D capitalization and amortization changes, contact your HPG team to help with impact and planning.