An update to IRC Section 174 took effect January 1, 2022 that will impact the R&D Tax Credit for startups.
What is IRC Section 174?
IRC Section 174 dictates how research and experimental expenditures are classified for tax purposes. For an expense to be claimed as part of an R&D study, it must first be classified as an IRC Section 174 expense.
What was the law before TCJA?
Prior to the Tax Cuts and Jobs Act (TCJA) in 2017, companies claimed R&D expenses as ordinary and necessary business expenses under IRC Section 162 and were able to deduct them in the same year.
This has meant your P&L would include R&D accounts with expenses for engineering, software, and so on which are used in calculating the total R&D claim, and those amounts could be claimed as a credit on your tax return in the same year that you paid those expenses.
How did TCJA change IRC Section 174?
TCJA states that as of January 1, 2022, companies can no longer take this approach.
As of January 1, 2022, the R&D claim must be amortized over a five-year period for domestic R&D claims and over a 15-year period for international R&D claims.
How will this affect Startups?
Overall, your R&D amount will remain the same, but it will now take longer to write off these expenses.
The delay in writing off these expenses could increase your short-term tax liability, putting your company in a profitable, taxable position. This could require estimated tax payments too.
In addition, due to the difference from tax to GAAP accounting, each year an adjustment will need to be calculated for your tax return. And, because this is considered a change in accounting, there are statements that need to be added to your tax return. If you have both domestic and international R&D, you may want to start capturing those amounts in separate accounts.
You may have to take a closer look at the cost/benefit analysis of doing R&D abroad vs. domestically.
How does this relate to the R&D Credit?
Although many Section 174 expenses are also eligible for the R&D Credit, there are also many Section 174 expenses that are not. Additionally, having Section 174 expenses does not automatically qualify a company to take the R&D Credit. All facts and circumstances about a company need to be evaluated, including age, industry, previous tax returns, and current financial statements. If found to be eligible for the R&D Credit, all Section 174 expenses need to be further analyzed to determine which are eligible for the R&D Credit under Section 41 (a subsection of Section 174 expenses).
Essentially, although all companies are now subject to Section 174 rules, this does not change their eligibility (or lack of eligibility) for the R&D Credit.
Essentially, although all companies are now subject to Section 174 rules, this does not change their eligibility (or lack of eligibility) for the R&D Credit. Just as in previous years, a full analysis will still be required to reap the benefits of this credit on the company’s tax return.
Estimate your startup’s potential R&D credit with our R&D Tax Credit Calculator.
How can Burkland help?
Our experienced R&D and Income Tax Teams can help you with all facets of this new legislation – from calculating your newly required book-to-tax Section 174 adjustment, evaluating your R&D Credit eligibility, calculating your R&D credits and providing you with an R&D Credit Study, and answering any questions you may have related to this change.