While there is no impact to accrual-based financial accounting, the rules on how R&D expenses can be deducted for tax purposes have become less favorable. Before this new legislation took effect companies could fully deduct R&D expenses on the tax return in the year they were incurred. In general, startups with high R&D costs could anticipate a non-taxable loss with no income tax due.
Internal Revenue Code Section 174 rules have changed for tax years 2022 and beyond; taxpayers may no longer currently deduct 100% of R&D expenses on their tax returns. Instead, taxpayers must capitalize and amortize specified research and experimental expenses ratably over five years for domestic R&D and 15 years for international R&D expenses.
Section 174 R&D expenses include research or experimental expenditures which are paid or incurred in connection with the taxpayer’s business in developing a new or improved product or process, as well as software development expenses. New guidance from the IRS has expanded these non-deductible costs to include research and experimental wages, software & hosting fees, R&D supplies, machinery & equipment, contractor payments, all elements of compensation, overhead costs, patent fees, and associated depreciation/amortization expenses.
There is no impact to your accrual-based financials – this adjustment only impacts the timing of income tax return deductions. You will observe no change to your financial statements.
Any corporation conducting research and experimental activity will be impacted. In particular, taxpayers with R&D expenses that would qualify for the R&D tax credit under Section 41 of the tax code are subject to the new Section 174 capitalization and amortization requirements. The adjustment is required in order to remain in tax compliance.
Kruze is identifying all relevant Section 174 costs, calculating the 2023 income tax adjustment for federal/state tax returns, tracking the amortization schedule over time, and filing all the necessary disclosures on the tax return. This process is performed at no additional charge, as the service is included in your pre-approved tax package.
Numerous legislative attempts have been made to repeal or delay the Section 174 capitalization requirement, and both Kruze Consulting and the larger business community anticipated changes before the end of 2022. This unfavorable adjustment is greatly impacting the incentive to conduct research and experimental activity, despite the recent increase in the R&D payroll tax credit threshold from $250K to $500K.
Bipartisan legislation that would repeal the Section 174 capitalization requirement was introduced in the House and Senate in 2021, but failed to pass. Other attempts were made in 2022 to delay the Section 174 requirement, including in the year-end spending bill, but also failed to pass. The tax preparation community was caught by surprise by Congress’ failure to act to repeal this legislation, and its impact is being felt by companies both large and small. The IRS has provided guidance on the identification and amortization of specified research and experimental expenditures under Internal Revenue Code Section 174.
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