Section 174 amortization
For tax years beginning on or after Jan. 1, 2022, R&E costs must be amortized over five years if the R&E activities are performed in the U.S., or over 15 years if the activities are performed outside of the U.S., beginning with the midpoint of the tax year in which the costs were paid or incurred. Furthermore, taxpayers may not immediately deduct the unamortized basis attributable to R&E costs for any property disposed of, retired, or abandoned during the amortization period (in other words, the amortization continues for its remaining life).
Because immediate expensing of R&E costs has been permissible for nearly 70 years, it was not necessary to distinguish R&E costs from other immediately deductible expenses. Therefore, for many taxpayers, additional effort will be necessary to comply with Section 174 if it doesn’t get repealed or delayed before their tax returns are due. The extent of that effort will depend on the size of the taxpayer’s business, the industry, the taxpayer’s global footprint, and the taxpayer’s current methods for characterizing these expenses.
In addition, taxpayers will have to consider how capitalizing R&E costs would affect the following:
- Cash flow impact. Taxpayers should plan for the impact on the increase in estimated tax payments needed to cover additional federal and state tax liabilities due to the deferral of R&E deductions.
- Tax provision impact. The TCJA provision creates a disparity between the timing of deductions for R&E costs for GAAP and the timing of deductions for income tax accounting purposes. Therefore, taxpayers should determine how they will account for deferred tax assets attributable to capitalized R&E costs.
- Foreign tax issues/Section 199A deduction. The allocation of R&E costs under Treasury Regulation Section 1.861-17 affects foreign tax credit usage, the foreign-derived intangible income (FDII) deduction, global intangible low-taxed income (GILTI), the base erosion and anti-abuse tax (BEAT), the determination of effectively connected income, and the Section 199A qualified business income deduction. Taxpayers should consider the impact that the deferral of deductions for R&E costs will have on these items.
- Tax accounting method changes. Taxpayers historically have been required to file an automatic accounting method change to change from expensing to capitalizing R&E costs. This method change had been on a cutoff basis without requiring an IRC Section 481(a) adjustment, meaning changes were applied on a prospective basis. Currently, the procedures for implementing the TCJA change to IRC Section 174 have not been published. While the IRS could require a method change similar to the current automatic change, this is not the only way that the law could be implemented.
- Loss on abandoned projects. Historically, taxpayers choosing to capitalize R&E expenditures for specific projects were permitted to write off the remaining basis if the project was disposed of or abandoned. Under TCJA, taxpayers are required to continue to amortize R&D expenditures over their remaining useful life. This rule seems contrary to other provisions in the IRC relating to abandonment costs, such as IRC Section 165.
- R&D credits. Federal and state R&D credits are available to taxpayers that meet the qualification criteria outlined in IRC Section 41. The credit qualification criteria specify that qualified research expenses must meet the definition of R&E expenditures under IRC Section 174. Consequently, taxpayers should consider how capitalizing qualified research expenses will affect the R&D credit. On the bright side, a more thorough analysis of R&E costs might result in opportunities for additional R&D credit benefits. Of note, even if a taxpayer is not claiming an R&D credit, the requirement to capitalize and amortize R&E costs still is applicable.
- State and local tax. For states that use federal taxable income, the requirement to capitalize and amortize R&E costs could increase the tax liability at the state and local level.
Looking ahead
Taxpayers have called for deferral or repeal of the Section 174 amortization requirement. While there is bipartisan support for some type of relief, it is unclear whether a legislative fix will be enacted. Because of the time and resources needed to comply with Section 174, taxpayers that haven’t already done so should evaluate how capitalization under Section 174 will affect them. In addition, taxpayers should have a plan to identify, track, and estimate applicable R&E costs to comply with Section 174 amortization if the provision is not delayed or repealed. For many taxpayers, significant work will be required to determine amortizable costs under Section 174.
