Research & development (R&D) drives innovation, competitiveness, and job creation in many industries. But in case you missed it, the Tax Cuts and Jobs Act (TCJA) altered Section 174 of the tax code that allowed companies to fully expense R&D costs in the year incurred. R&D costs are now amortized over five years for domestic costs, and 15 years for foreign R&D. The rule also includes software development costs. Read on to find out what this means for your business.
What you need to know about the R&D tax credit change
For tax years prior to December 31, 2022, businesses could wholly expense R&D costs in the year they were incurred. Now, these deductions are spread over multiple years (amortized), effectively increasing the cost of innovation for large and small companies alike. Companies that have invested heavily in R&D may face higher-than-anticipated tax bills for 2023.
Multiple groups have sent letters to Washington urging lawmakers to restore the provision. Organizations like the National Association of Manufacturers (NAM) have rallied against the change in anticipation of losing thousands of R&D jobs and the erosion of future U.S. competitiveness if this tax amendment remains unaddressed. But what about the many small and medium businesses that don’t have lobbying arms—just massive tax bills? We suggest consulting with a professional tax consultant to help manage the change.
Which entities are subjected to Section 174 capitalization?
- Small businesses and startups
- Sole proprietorships, partnerships, and LLCs
- Pass-through entities (S-Corporations)
Costs subject to Section 174 capitalization
- Salaries and wages of employees conducting, supervising, or supporting research activities
- Costs associated with research-related supplies and equipment
- Expenses linked to obtaining patents for products or processes developed through research
- Indirect expenses like utilities for research labs or depreciation on research equipment.
- Costs from third-party research conducted on a company’s behalf.
- Software development expenses
What’s excluded from Section 174 deductions?
Not all R&D expenses can be deducted under Section 174, such as costs for:
- Land or depreciable properties
- Research conducted after the beginning of commercial production
- Marketing research
- Quality control
- Funded research (such as research funded by any grant, contract, or otherwise by another person or governmental entity)
How to use grants and R&D tax credits
In a typical scenario, a business just starting R&D has the opportunity to seek a grant as the initial investment for their project. Following a year or two, they might pursue the R&D tax credit to fund further research (provided the R&D passes the funded research tax exclusion).
Funded grants count toward income for tax purposes, and even an entity that has spent all of the grant money will have to claim the income but may be unable to offset it fully in one year due to the amortization of expenses. We recommend speaking with a qualified tax advisor before you panic. There may be relief with ASC 606, or how the income from those grants is recognized in the method of accounting. We can also assist with reporting and cash flow timing for nonprofit grants that require cost reporting.
What types of grants can co-exist with the R&D tax credit?
In some cases, the following grants can co-exist with the R&D tax credit:
- Small Business Innovation Research (SBIR)
- Small Business Technology Transfer (STTR), also known as America’s Seed Fund.
Both programs provide the early-stage capital that small businesses often need to conduct R&D. The STTR grant is similar to the SBIR in most regards, except that it requires small businesses to partner with a nonprofit research institution based in the United States.
What if I don’t have a tax liability? Is the R&D tax credit worth claiming?
If your company meets the definition of a start-up, you may be able to claim a payroll tax offset of $250,000 each year for up to five years on your payroll tax returns. The payroll offset is only available on an originally filed return.
Regardless of whether you meet the definition of a start-up, the tax credit may be carried forward for up to 20 years to offset future tax liabilities and may mitigate the cost of the 174 addback to income for qualifying companies.
Seek expert guidance
FSA offers expertise and assistance for taxable entities grappling with how to deal with ever-changing tax regulations. We’re here to ensure your financial stability and resilience even in the face of tax upheavals. Contact us to schedule a consultation.