Barring swift action from Congress, capitalization rules will be applied to research and development (R&D) costs beginning in January 2022. This means R&D and software development expenses previously eligible for immediate expensing will be required to be deducted over a five-year or 15-year period.
These shifts will have a major impact on the deductibility of payroll costs that are used to determine allowable R&D expenses, and companies may experience dramatic swings in income if Congress does not act to change the current laws.
The R&D tax credit, originally introduced in the Economic Recovery Act of 1981, has been extended on numerous occasions, with the most recent update occurring with the Tax Cuts and Jobs Act in 2017.
For the legislation to pass, the budget reconciliation process required a revenue-neutral tax bill. Limitations were made on numerous deductions to achieve revenue neutrality, with the legislature including a provision limiting the R&D tax credit for tax periods beginning after December 31, 2021. This provision will create a significant change to the treatment of R&D expenditures under IRC Section 174.
Prior to the enactment of the Tax Cuts and Jobs Act, businesses had the option to deduct R&D expenses in the year incurred or capitalize expenses over 60 months. Effective January 1, 2022, R&D costs will no longer be eligible for immediate deduction in the year incurred, unless Congress passes House Resolution 1304, or the American Innovation and R&D Competitiveness Act of 2021.
The Tax Cuts and Jobs Act requires R&D and software development cost to be capitalized and deducted over a five-year period if the activity takes place in the U.S. or a 15-year period for activities are in a foreign country. The shift will be considered an accounting method change with further guidance to come on whether the election will be an automatic method change filed on Form 3115.
These changes will apply to expenses regardless of whether the taxpayer claims an R&D credit on their tax return. As of now, according to the current language in the law, any expense that would have otherwise qualified as R&D will need to be capitalized.
The IRS has not released regulations to explain what costs are considered qualified R&D expenditures. Without guidance, businesses can expect all costs related to R&D activities to be capitalized, regardless of whether the cost is for internal advancements or services provided to a client.
Congress will likely not address the R&D credit or decide on House Resolution 1304 prior to the end of the year, allowing the capitalization requirements to go into effect on January 1, 2022. Businesses should begin preparing for the capitalization changes through modeling and tax planning.
Stay tuned to this blog and our social media channels for further updates on these dramatic changes.
If you have any questions about the information above, please contact your E. Cohen advisor.
Connor Boyle, CPA
Connor Boyle, CPA
Connor Boyle, CPA is a Staff Accountant (Level 2) in the Tax Department at E. Cohen. He is responsible for assisting the firm’s Tax Department with accurate and timely tax services.
Connor is an experienced tax professional with Section 382 tax services, transaction cost recovery, and legal entity rationalization experience.
Prior to joining the firm, Connor worked as a Tax Consultant at Deloitte, where he served clients in a variety of industry sectors including energy, pharm