Many taxpayers feel like the recent, unprecedented changes to Section 174 completely blindsided them. These changes to the research and development (R&D) space were effective January 1, 2022, but the question they are asking is—Now what? Taxpayers and their professional advisors are still reeling from the substantial financial impact on tax liabilities and the major cashflow crunch the changes have caused.
What is Section 174?
Section 174 refers to the Internal Revenue Code about research and experimentation (R&E) expenditures. This lesser-known but vital provision plays a crucial role in fostering innovation and driving economic growth, allowing businesses to recoup their R&D expenses through tax deductions.
Who is Subjected to Section 174?
Unfortunately, this is a very broad-reaching area of the tax law. It applies to taxpayers who must deal with uncertainty and solve problems to earn revenue. It doesn’t matter whether taxpayers claim the R&D tax credit or not. Regardless of whether taxpayers choose to claim the R&D tax credit, many will still be caught by its far-reaching impact.
How Have the Recent Changes Affected Taxpayers?
This area of the law now requires taxpayers to identify their R&D activities and associated costs. Once those are identified, the amounts are capitalized for federal income tax purposes and amortized over a five-year period for domestic costs and a fifteen-year period for international costs. This is the main pain point for many taxpayers.
Specifically, there has been a brutal hit to engineering firms, architecture firms, software development companies, and manufacturers. Every year these and other types of taxpayers perform R&D activities including, providing product designs, specifications, blueprints, and enhancements. Unfortunately, those costs can no longer be deducted as incurred.
For example, an engineering firm, to serve its clientele, has engineers, drafting technicians, and other employees who focus daily on solving problems and creating solutions that rely on engineering principles. In today’s tax world, companies like this must capitalize and slowly deduct the costs of running their businesses. Expenditures like salaries, intellectual property attorneys, and design drawings were previously immediately deductible before recent modifications to Section 174. Despite the cash outflow to cover these expenses, businesses now find themselves in a situation where they must wait to deduct these costs over an extended period.
What Are Some Examples of R&D Expenditures?
- Attorney fees related to patents
- Patent costs
- Depreciation of equipment used in R&D (i.e., computers, milling equipment, etc.)
- Utilities allocable to R&D
- Wages paid to those doing R&D
- Supplies consumed in R&D
- Prototypes
How Can Calvetti Ferguson Help?
Our team assists clients in understanding these confusing rules and helps them avoid classifying too much as a R&D expenditure needing to be capitalized. We review what taxpayers did initially to address their R&D activities to identify opportunities and mitigate the impact of this unexpected tax law change. This is an area with limited guidance so, establishing best practices now and monitoring new information is critical.
Notably, other tax incentive areas, such as cost segregation studies and energy-efficient building deductions, can be effectively used to offset much or all of the impact of the new Section 174 requirements.
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