Companies Should be Aware of the New Research and Development Expense Capitalization Rules for Their 2022 Financial Statement Reporting
As tax season winds down and companies begin to prepare their first quarter 2022 financial statements, they need to be aware of a significant change in how they will calculate their taxes for financial statement purposes.
As part of the Tax Cuts and Jobs Act (“TCJA”) of 2018, Code Section (“IRC”) 174 Research and Development Expenses (“R&E”) was changed, but it was not scheduled to go into effect until 2022.
Under the new tax law, a company is required to amortize its R&E expenses over the following periods – using a midpoint of the year method for the start of the amortization period:
- For tax years beginning after December 31, 2021, companies must capitalize and amortize their R&E for tax purposes incurred in their trade or business over the following amortization periods using a straight-line methodology:
- Five years for research expenses that take place in the United States
- 15 years for research expenses that take place outside of the United States
- For tax years before 2022, companies had options concerning R&E expenses. They could:
- Deduct them currently as an expense
- Capitalize and amortize them over a period of not less than five years (starting in the period the company derived the benefit of the research)
- Amortize software development costs that were akin to IRC 174 R&E over three years
- Select any of the above options
Companies with R&E need to consider the impact on their 2022 financial statements and beyond.
Most companies choose to deduct their R&E expenses currently. So if your company was one of those and you incur R&E, starting in 2022, you must change your method of how you treat R&E for tax purposes. If you are changing from expensing R&E historically to the newly required method for R&E, you will need to set up a deferred tax asset for the remaining unamortized R&E life.
The new rules require amortization of R&E to be amortized, even if the research and development project is scrapped or abandoned. Also, In the past, unless a company was claiming a Research and Development Credit (“R&D”) under IRC 41, they didn’t worry about separately identifying costs as R&E. This was because they were deducting them currently, so there was no need to separately identify costs as R &E.
The only exception would perhaps be for pass-through entities that needed to identify the costs for their passive partners or shareholders for alternative minimum tax purposes (for AMT purposes passive partner/shareholder that do not materially participate in the operations of the business are generally required to amortize their share of R&E over 10 years).
Even if a company is claiming an R& D credit under IRC 41, they will still need to identify all their R&E because only specific IRC 174 R&E expenses qualify for the R&D credit under IRC 41.
However, be aware that the definition of R&E is much more expansive than just the costs that qualify for the R&D tax credit. For example, travel expenses are not allowed for calculating the R&D credit but may be considered R&E for purposes of IRC 174.
If you have any questions about the onset of the new change to the R&E capitalization rule, please contact Doug Finkle at doug.finkle@sobelcollc.com
