This article was first published by Forbes.
Last year, I wrote an article detailing the tax law change that took effect on Jan. 1, 2022, trying to warn tech companies about the potential effect on cash flow if they have significant research and experimental (R&E) expenditures.
While we did see some companies plan ahead, the prevailing wisdom at the time, including published communication in the Senate, was that opposition to this law change would eventually lead to a retroactive change in the law. Fast forward to today and we are still waiting for guidance from the IRS or, in many cases, a Hail Mary fix from Congress to retroactively strike down the law change. Considering the law change is now well into its second year, I thought it would be a good time to identify what we have learned since last April, and what new uncertainties exist.
While it sounds straightforward, without significant regulations to guide taxpayers, the answer is still very unclear. The Research and Development Credit in IRC Code Section 41(d)(1)(A) now references that in order to be eligible for the credit, the cost must be “treated as specified research and experimental expenditures under section 174.” This means the calculation of your R&E expenditures starts with any credit-eligible wages, supplies, or contractor costs. After that, older regulations and revenue procedures, such as IRC Regulation 174-4, indicate that a number of overhead items including depreciation, utilities and payroll taxes require inclusion. A code section like 263A has voluminous regulations to answer very similar questions, so it is not surprising to see the IRS is not rushing to finalize this guidance.
With some uncertainty about what constitutes a “Section 174 research and experimental expense,” businesses are left to rely on older guidance leaving some ambiguity about which expenses must be capitalized, and which can still be expensed. Some examples of Section 174 expenses are:
- Salaries and wages of employees engaged in research and experimental activities
- Cost of materials and supplies used in research and experimental activities
- Depreciation of equipment used in research and experimental activities
- Rent and utilities for facilities used in research and experimental activities
- Cost of testing and evaluating products or processes
- Cost of obtaining patents or copyrights
- Cost of consulting fees paid to experts in research and experimental activities
It is important to note that not all expenses incurred in connection with research and experimental activities are considered Section 174 expenses. The expenses must be incurred in connection with activities that are intended to discover information that would eliminate uncertainty concerning the development or improvement of a product, process, software, technique, formula, or invention.
For example, the cost of marketing a new product would not be considered a Section 174 expense, as it is not an activity that is intended to discover information. However, the cost of conducting market research to determine the feasibility of a new product would be considered a Section 174 expense.
If you are unsure whether an expense is a Section 174 expense, consult with your tax advisor.
As the final deadlines for the 2022 tax filing season approaches, a last-minute reprieve from these rule changes has become extremely unlikely. In June, the Build It in America Act was introduced and included retroactive changes to repeal the changes, so support still remains for a change, but given the timing, we’ll likely look to the next tax season for any changes.