Vol 2023 - 4 Change in Sec. 174: Required Research and Experimental Expense Capitalization

Rödl & Partner Tax Matters Volume 2023-4, published February 10, 2023

An important consideration for the preparation of our clients' 2022 tax provisions (now) and 2022 income tax returns (later this year) relates to a change in tax law regarding the deductibility of research and experimental expenses.  

Legislative Background/Change in Law 

The Tax Cuts and Jobs Act passed at the end of 2017 modified Section 174 of the Internal Revenue Code (“IRC”) such that taxpayers must amortize research and experimental (“R&E”) expenses that were previously deductible for tax years beginning in 2022. The amortization period for such costs is dependent on whether the costs in question are domestic (5-year amortization) or foreign (15-year amortization) in nature. The general expectations from tax professionals were that later last year legislation would be passed to reverse or delay the effect of this change in tax law, but it appears for now at least this provision of the law will remain unchanged.

Overview of IRC §174 Expenses

IRC §174 generally defines an R&E expense as any expense for product research and development activities in the experimental or laboratory sense where there is uncertainty related to the appropriate path forward in the development or improvement of the product or its design. A product in this case is defined as any pilot model, process, formula, invention, technique, patent, or similar property to be used by our clients in the course of their business or to be offered for sale, lease, or license to their customers. Common examples of these expenses include:

Wages paid to employees who were directly involved in R&E activities and the individuals who directly supervised or supported their work

• Supplies and raw materials utilized in design, fabrication, or testing that were expensed during the tax year
• Work performed by a third party in our client’s business assumed the brunt of the economic risk, regardless of the outcome
• Costs related to obtaining patents
• Related party charges for development activities performed both domestically and abroad
• Depreciation expense on facilities and machinery/equipment utilized for R&E activities

Implications and Opportunities

The practical result of this change in tax law is a deferral over several or more years of the deductions historically immediately available for research and experimental expenditures. The impact will be smoothed over time assuming a relatively static level of R&E spend as new layers of amortization are introduced each year. However, the impact for the 2022 tax year can be substantial depending on the subject taxpayer’s current development spend.

One opportunity to offset some of the impact of these deferred deductions is to consider having a research and development tax credit study performed. These studies help our clients to identify potentially valuable credits available to them at both the Federal and state levels.

Please do not hesitate to contact your Rödl representative for more information or if you would like to explore  the opportunities around R&D tax credits.

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