Charles R. Kennedy, CPA, MBA
Vice President & Director of Tax Services

Companies that have taken advantage of the research & development tax credit to lower taxes and recoup costs related to R&D activities will be subject to a major change this year that may significantly boost their taxes.

A new rule requiring R&D-related costs to be capitalized and amortized became effective for R&D-related costs incurred after December 31, 2021. This means many of the expenses in 2022 that previously would have qualified for the R&D credit – which allowed taxpayers to immediately recover qualified costs – now will have to be amortized over five years. Any foreign R&D expenditures will be amortized over 15 years.

While the R&D tax credit still exists and no changes have been made to the credit itself, the application of the credit is now largely offset by this amortization requirement.

The impact of this new rule will fall most heavily on manufacturers, technology and biotech companies and other industries that engage in sustained R&D activities.

Background

The R&D tax credit was enacted in 1981 to address concerns that U.S. economic performance had fallen below its potential. In 2015, Congress made the credit permanent. But two years later, the Tax Cuts and Jobs Act of 2017 was enacted, including the capitalization and amortization rule, which would help pay for other features of the TCJA.

The capitalization and amortization rule didn’t get widespread attention when TCJA passed in 2017 because it wasn’t scheduled to take effect for another five years.

It is now five years later. While a legislative effort was made in Congress last year to reverse this rule, the legislation did not pass. Whether Congress will act this year to reverse the rule retroactively remains to be seen.

Under the new law taxpayers must capitalize and amortize R&D costs, whether or not they take the R&D tax credit. Moreover, the expenditures that are required to be amortized are broader than those that qualify for the R&D credit.

To qualify for the R&D credit, activities and expenses must meet four criteria set out in IRC Section 41. Under the new rule, an activity may meet only three of the four criteria, but would still be required to be capitalized, even though on its own it never would have qualified for the R&D credit. Consequently, taxpayers will find expenses on their books that are subject to five-year capitalization and amortization for the first time.

At the state level

The majority of states – including Massachusetts, Connecticut and Rhode Island – have R&D tax credits that mirror the federal credit. While states have the option of “decoupling” from federal practice when they have similar or identical tax laws, in this case it appears most states will follow the federal government’s lead. So, taxpayers will deal with the same issues at both the state and federal levels this year with regard to R&D expenses.

If you have questions about how this change will impact your company, contact your GT Reilly advisor.