R&D Expense (Mis)Treatment

By Josh Lapierre February 9, 2022

Co-authored by Stan Rose

(Congress makes significant changes to R&D tax treatment)

The Research and Development (“R&D”) tax credit seemingly has never received the respect it arguably deserves, and effective for tax years beginning after December 31, 2021, it indirectly is kicked to the curb once again.

The Internal Revenue Code (“IRC”) is riddled with characteristics designed not solely to raise revenue, but to encourage social and commercial goals. Encouraging development is one such goal, but Congress has a long track record of treating the R&D credit as a bargaining chip or an afterthought, with the credit historically being renewed only for one year at a time, often retroactively, well after the applicable year had started, or even months after the year had ended. This annoying death-and-defibrillator approach led to many taxpayers being forced to file amended returns to obtain the credit, because they were unable to do so with timely-filed original returns.

Observation: Although not the subject of this article, another recent change has been made in the R&D tax arena, impacting amended returns. Effective just weeks ago, significantly more supporting detail is required to be attached to amended returns that are filed to obtain the R&D tax credit. More details can be found in IRS Memo IR-2021-203 and IRS Chief Counsel Memo 20214101F.

After decades of such mistreatment, the credit finally was made a permanent part of the IRC with the passage of the Path Act of 2015. However, the honeymoon lasted for only two years before 2017’s Tax Cuts and Jobs Act (“TCJA”) kneecapped the credit once again – not by eliminating it, but by dramatically altering the treatment of costs that generate the credit – whether or not the credit is claimed. It set in motion delayed changes that are effective now.

Most R&D costs are tax-deductible when incurred. The credit, which is based on those costs, is gravy, providing even more bang for a taxpayer’s buck. The R&D credit converts deductions, which reduce the amount of net income subject to tax, into credits, which reduce the actual tax. Credits are on a dollar-for-dollar basis much more potent than deductions. There are multiple variants of the R&D credit, but generally the IRC prevents double-dipping by (1) prescribing computation of the credit (based primarily on qualifying R&D expenses), but then also (2) requiring the underlying expense deduction to be reduced by the amount of that credit. The larger balance of R&D costs on which the credit was based (the excess over the credit amount) continue to be deductible… until 2022, that is.

Apparently no longer finding it sporting to target the credit directly, Congress used the TCJA to instead level its crosshairs on the underlying expenses. It allows continued use of the credit, but effective for tax years beginning after December 31, 2021, most R&D expenses must be capitalized and amortized over a number of years rather than yield a current deduction. The recovery period is 5 years for U.S. costs and 15 years for international costs. Significantly, this treatment is required not only by taxpayers who utilize the credit, but also by those who don’t. Therefore, this will impact entities who until now may not have carefully identified which types of expenditures fall into the R&D “bucket,” because most are drawn from other types of expenses, such as wages incurred by those conducting the R&D, or supplies.

One of the pieces of legislation bundled into President Biden’s much larger Build Back Better proposal promised to salvage the currently-deductible treatment – or at least defer its demise for a few years – but that legislation stalled in the Senate late last year, and its status is very much unknown.

This means that unless remedied by future legislation with retroactive reach, deductibility of costs incurred beginning last month will not be immediately deductible as in the past, but will be spread over several years. Taxpayers – especially those for whom R&D represents a significant outlay – should begin budgeting for increased taxes as a result. As is the case anytime Congress monkeys with federal tax rules, taxpayers also should buckle their chinstraps to see whether applicable state income tax rules will follow suit or part ways.

For more information, please contact your BNN tax service provider at 800.244.7444.