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Clock Winding Down for Congress to Delay New Rules for R&D Expenses
“March Madness” has a special meaning amongst the basketball-loving business owners and taxpayers of the Triangle. This year, it also describes the angst that CPA firms and their clients are facing as severe new tax rules governing taxpayers’ “Research and Development” activities come into effect. If you are thinking – “our Company doesn’t do any R&D, and we don’t claim the R&D credit…I’ll skip this” then – to follow the basketball analogy – beware of the unintentional foul coming your way… you may want to read on.
Let’s start with a brief recap of what is different about this ‘season’
One of the revenue-raising provisions of 2018’s Tax Cuts and Jobs Act was the major change to the allowance by the IRS for taxpayers to expense in the current year the expenses incurred related to R&D. Instead, taxpayers would be required to capitalize and amortize the expenses. The amortization period is 5 years for R&D activities performed in the US and 15 years for foreign-based R&D. This was a tax-raising offset to help manage the lost tax revenue caused by lowering the corporate tax rate to 21%, as well as other taxpayer-favorable provisions. But, Congress be wanted to give taxpayers (and voters) the good news first, and delay the associated pain that would be involved. This resulted in a deferred effective date for the new R&D rules – even though the legislation was passed in late 2017, the new R&D rules weren’t slated to come into effect until the 2022 tax year. So, most taxpayers and some of their advisors happily went along their way, enjoying the lower rates and other perks. Now that 2022 is upon us, let’s take a look at an example of how serious of an impact this new rule can have:
Simple Example: Innovations, Inc. is a grant-funded company pursuing some exciting new technology. Their business model for the last 5 years has been to obtain grant-funding and spend nearly all those funds in R&D endeavors in the U.S. For 2022, they receive $2mm in grant funding and spend all of the $2mm on wages, supplies, rent, etc. – all associated in pursuit of their new and improved technology. Under the ‘old’ rules, the Company has $2mm of revenue and $2mm of deductions in 2022: taxable income of zero. Under the “new” rules in effect: Innovations, Inc. has $2mm of revenue and only $200k of amortization expense for 2022 (1/2 year of $2mm of amortization over 5 years), equaling taxable income of $1.8mm. At a 23% Federal and state tax rate, cash tax burden of just over $400k. But, the Company has spent all of it’s $2mm of revenue on R&D expenditures. How does it pay the tax?
R&D: Not Just Microscopes and Lab Coats
Not to dive too deeply into the tax-nerd pool, but, some technical jargon is important for context. Internal Revenue Code Section 174 is what governs how taxpayers treat R&D. The majority of all of a taxpayers’ ‘ordinary and necessary’ business expenses are allowed as a deduction under Code Section 162. Historically, whether expenses fell into the Sec. 174 category or Sec. 162 category didn’t really make that much of a difference – since both provisions allowed for expensing in the current year. However, now the definition of ‘R&D’ (governed by Sec. 174) is of vital importance. What constitutes R&D, or, as Sec. 174 refers to it ‘R&E’ (Research & Experimentation) can generally be described as: costs for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product, process, software, technique, formula, or invention. Sound broad? It is. Also to note: internally developed software is considered R&E as well. Some guideposts for consideration: If a Company gets a financial statement audit or review under GAAP, most likely R&D (or R&E, whatever your liking) would be segregated and presented as a separate line item on the income statement. That’s a staring point for tax, but, the GAAP definition of R&E doesn’t exactly mirror Section 174. If a taxpayer has historically claimed an R&D tax *credit*, then, the qualifying expenses identified under that exercise are considered R&E as well. But, caution – the new rules around expensing R&D operate totally independent of the R&D tax *credit* provisions – just because a company doesn’t qualify for the R&D tax credit does not mean the new Sec. 174 rules don’t apply. Or, said another way – foregoing claiming the credit does *not* mean a Company doesn’t have R&D expenses. Suffice to say, under the new paradigm of capitalizing R&D, taxpayers are going to have to pay much more attention to what costs fall under the Sec. 174 definition.
We’re the Government and We are Here to Help!
The fact that the new rule is a detriment to innovation and growth has strong bi-partisan agreement, with both Democrats and Republicans generally agreeing that it’s just ‘bad policy’. The message out of Washington for the last 2 or so odd years has been that some fix – whether repeal of the new rule, or at least a delay, would be forthcoming. Most taxpayers and their advisors have been expecting some form of legislative fix – and have based their 2022 estimated tax payments and cash-flow accordingly. Alas, with Congress as divided as ever (maybe more so), things couldn’t be that easy. As it currently stands, the Republican members of Congress are strong champions of changing the new rule, with their Democrat counterparts willing to play along….but wanting to get something in return. The Tax Cuts and Jobs Act was a Republican-led legislative event, and Democrats are taking the “we didn’t create this problem” approach. The main pawn in the negotiation appears to be the child tax credit, with Democrats wanting that provision restored in return for agreeing to the R&D fix. Lobbying efforts from an array of interested parties – ranging from industry and trade groups, to taxpayer advocacy think-tanks, to professional associations such as the American Institute of Certified Public Accountants have all written strongly-worded letters to their Congressmen. There has been much talk, but little action. Whereas tax professionals have been optimistic about a change in the rules, that sentiment is quickly turning to cynicism with the looming 2022 filing deadlines of March 15th and April 15th.
Game Plan as the Clock Winds Down
The window for “wait-and-see” is quickly closing, since extension payments in relation to the 2022 calendar tax year come due April 15th. Prudent taxpayers are, at a minimum, encouraged to ‘extend’ their 2022 income tax returns. There is still some hope, albeit diminished, that some legislative change will occur, and be retroactive back to the 2022 tax year. But, even absent a delay or repeal of the new rules, the IRS has indicated that they plan to issue additional guidance addressing nuances of the new law, which will also hopefully clarify the distinction between R&D expenses and other ‘ordinary and necessary’ business expenses under Sec. 162. The last few tax years included various COVID-related tax provisions that have resulted in many taxpayers having to amend already-filed tax returns after new or improved legislation was enacted. Given the disfunction at the IRS in processing returns, the last thing taxpayers want is to be faced with amending returns if it can be avoided. While some judgement calls will need to be made regarding extension payment amounts, taxpayers would be well-served to wait to file 2022 income tax returns until all available information and guidance can be obtained from Congress and the IRS. So, if you’re used to filing your returns on time, and your tax professional recommends extending: listen to the coach.
To conclude under the analogy we started: there’s only about 5 minutes left in the game, the home team is down by double digits, the refs are making bad calls, and we have one time out left.