Tax Changes Incoming for Research and Experimental Expenditures

Update (12/23/22): In the omnibus spending bill passed by Congress, no changes to the Section 174 rules requiring capitalization and amortization of research and experimentation expenses were included in the final bill of 2022. So, required capitalization will be fully applicable to the 2022 tax year.

For tax years beginning in 2022, research and experimental (R&E) expenditures are no longer immediately expensed but rather must be amortized over five years (15 years for foreign expenditures).

To illustrate, if a business spent $1,000 on domestic research activities in 2021, it could deduct the full $1,000 on its 2021 tax return. But, starting in 2022, $1,000 spent on research will be deducted incrementally over a five-year period; approximately $200. The reduction of currently allowable deductions ($800 in our example) could lead to a possible unexpected increase in taxable income, especially in the first few years that these rules apply.

How did we get here? This change to the tax treatment of R&E expenditures was included as a revenue raiser for the federal government to help pay for other tax breaks in the Tax Cuts and Jobs Act passed at the end of 2017.

Congress sometimes uses a special legislative process called “reconciliation” to quickly advance high-priority tax, spending, and debt limit legislation. This was the case with the Tax Cuts and Jobs Act passed at the end of 2017. This special legislative process of “reconciliation” comes with its own set of operating rules, one such rule being that the final legislative package must either increase or decrease revenue by a specified amount over a specified time.

So, for example, in 2017, to enact large tax cuts, the fiscal year 2018 budget resolution included instructions to the House and Senate tax-writing committees directing them to report legislation increasing the deficit by not more than $1.5 trillion over ten years. In other words, to pay for tax provisions that decreased federal revenues, there had to be tax provisions that off-set these decreases to achieve the targeted result; hence, the changes to the tax treatment of R&E expenditures.

The conventional wisdom back at the end of 2017 and the beginning of 2018, was that because the tax changes to R&E expenditures was not set to take place for 5 years in the future, Congress would act in the intervening years (we have seen this many times before, most notably with the Estate and Gift Tax Exclusion due to sunset at the end of 2025). Thus, far, Congress has not (but not without lack of trying).

There have been discussions in Congress to postpone the TJCA changes to R&E expenditures or repeal them entirely and restore the rules allowing immediate expensing of R&E expenditures. Unfortunately, these discussions seem to have stalled so far. Without any legislative relief, guidance from the IRS on implementation of the mandatory amortization post-2021 changes isneeded. To be perfectly blunt, this guidance is needed immediately for the 2022 tax year, especially for corporations that must prepare financial statements. The post-2021 tax treatment of R&E expenditures is inconsistent with financial accounting principles that requires most research and development costs to be expensed immediately.

To learn more about how the changes to R&E expenses could affect your business and for updates on the status of attempts to change the law, please contact us.

This alert serves as a general summary and does not constitute legal guidance. Please contact us with any specific questions.

Fraser Trebilcock attorney Paul V. McCord has more than 20 years of tax litigation experience, including serving as a clerk on the U.S. Tax Court and as a judge of the Michigan Tax Tribunal. Paul has represented clients before the IRS, Michigan Department of Treasury, other state revenue departments and local units of government. He can be contacted at 517.377.0861 or pmccord@fraserlawfirm.com.