Research & development costs (R&D), also called Research & Experimental expenses (R&E) are expenses paid or incurred in connection with the taxpayer’s trade or business which represent experimental costs intended to eliminate uncertainty in the development or improvement of new products. To qualify as an R&D cost, the expenditure must meet the 4-part test.
- They must be expenditures paid or incurred during the taxable year in connection with a trade or business and not chargeable to a capital account,
- Relate to research undertaken to discover information that is technological in nature,
- Relate to research that is intended to be useful in development of a new or improved business component, and
- Constitute elements of a process of uncertainty.
These costs are generally broader in range than those allowed in the calculation of the R&D credit. Expenditures for the acquisition or improvement of land, or improvement property to be used in connection with research or experimentation, and of a character which would be subject to allowances for depreciation are not expenditures allowed as R&D expenditures.
R&D expenses may include, overhead allocations, depreciation on property used in connection with the research and the costs associate with obtaining patents.
For 2022, the Tax Cut and Jobs Act (TCJA) made some significant changes in how the R&D expenses are reported for tax purposes, and how the R&D tax credit will be applied.
Prior to 2022:
- R&D expenses in connection with a trade or business can be deducted in full in the year incurred,
- or an election can be made to capitalize the expense and amortize over a period not less than 60 months.
- Software development
- Currently expense,
- or Amortized over a period net less than 60 months from the date the development is complete, or
- Amortize over 36 months from the date placed in service.
Under the new law:
- R&D expenses must be capitalized and amortized ratably, beginning at the midpoint of the tax year incurred, over:
- 60 months if R&D is conducted in the US, or
- 15 years if R&D activities are conducted outside the US.
- Software development costs are included in definition of R&D costs and amortized:
- 60 months if R&D is conducted in the US, or
- 15 years if R&D activities are conducted outside the US.
By amortizing starting at the midpoint of the year in the initial year is to allow one half of the annual amortization in year 1 and one half in year 6.
It now becomes even more important to start tracking R&D expenses. First, due to the different amortization rates between US incurred and foreign incurred R&D expenses. Secondly, to determine the overhead, administrative costs, and depreciation associated with each activity.
Another major change is with respect to any property disposed of, retired, or abandoned during the period under which they are being amortized, no deduction shall be allowed with respect to the disposition, retirement, or abandonment. Unlike the treatment afforded other items, amortization of R&D expenses continues until completely amortized with no acceleration of any unamortized portion.
For example, a taxpayer capitalizes $1,000,000 of R&D expenditures in year 1. In year 3 it is determined the project is no longer feasible and all work on the project is discontinued. There is no write off allowed for the unamortized expenditures; amortization continues for the full five-year period.
The TCJA’s changes in R&D cost reporting will not significantly change the R&D credit. Under the current law R&D expenses must be reduced by the amount of the R&D credit taken unless the taxpayer elects to take a reduced credit. The amount of the reduction in the credit is equal to the maximum tax rate. Prior to the TCJA the R&D credit would have been reduced by 35%, leaving the taxpayer with an effective credit of 65%. After the TCJA the reduction would be 21% with an effective credit of 79%. Effective January 1, 2022, capitalized R&D costs will need to be reduced by the amount of the credit being taken unless the taxpayer elects a reduced credit (currently 21%) at which point no reduction will be required. Taxpayers should be aware that the expenditures used in the calculation of the credit are more restrictive than what can be deducted. The following costs are not allowed for purposes of calculating the allowable credit:
- Overhear cost
- Administrative costs
- Depreciation/ amortization
- Patent costs
The TCJA has also changed treatment of software development costs. Currently under Rev Proc 2000-50 software development costs may be fully expensed in year incurred or an election made to amortize over a period of not less the 60 months from the date of development, or 36 months from date placed in service. Per the TCJA changes, software development costs are included in the definition of R&D costs and amortized over a 5-year period for costs incurred for development in the US, and 15 years for development outside the US. Current year expensing is no longer allowed. Software acquisition costs, of software develop by a 3rd party, can still be amortized over 36 months from the date the software is place in service.
Due to the extended amortization period on R&D activities performed outside the United States, taxpayers with foreign operations may want to consider relocating where their R&D activities are conducted in order to take advantage of the 5-year amortization period on US research activities over the 15-year amortization period on foreign research activities.
The TCJA has specified that these changes will be treated as a change in method of accounting method which will require the filing of form 3115. Currently, guidance has not yet been issued but it is anticipated that this will be done via an automatic method and implemented on cutoff basis. This means that only expenditures incurred on or after the implementation date will be considered in the method change. If you have any questions regarding the new R&D capitalization requirements and how it may affect you, please reach out to us at 973-994-9494.
