A provision of the Tax Cuts and Jobs Act (TCJA) taking effect for tax years beginning after December 31, 2021, requires taxpayers to significantly change the treatment of research and experimental (R&E) expenditures under Section 174.
Instead of currently deducting these expenses, taxpayers must amortize the costs over a period of five years for research conducted in the United States or 15 years for foreign research. This means taxpayers must determine the proper amount of their Section 174 costs as the treatment now differs from the treatment of otherwise deductible trade or business expenses under Section 162.
Prior to 2022, Section 174 allowed taxpayers to fully deduct R&E expenditures. These expenses include direct research expenses, like wages and supplies, and indirect research expenses, like overhead and administrative costs related to research activities.
Taxpayers previously deducted these expenses in the year they were incurred. Because the treatment of R&E expenditures under Section 174 did not differ from the treatment of ordinary business expenses deductible under Section 162, most taxpayers did not perform an analysis to determine whether business expenditures were properly classified as R&E expenditures under Section 174.
A common misconception is that Section 174 capitalization is only required if taxpayers are taking the R&D Tax Credit. In fact, all R&E expenses must be capitalized and amortized regardless of whether the taxpayer is claiming the R&D Tax Credit. And this is applicable for taxpayers with any amount of R&E expenses (there is no de minimis exception).
The impact of capitalizing Section 174 expenses differs based upon the unique facts of a taxpayer’s business, but the change may significantly increase taxable income if the law is not modified. Therefore, taxpayers will need to develop a plan to identify and track Section 174 expenses to ensure accurate tax filings.
Some taxpayers may not be able to fully pay the balance due on their 2022 tax returns due to unexpected increases to taxable income resulting from amortization of Section 174 expenses.
For example, individuals with a total balance due below $50,000 can request an Online Payment Agreement with the IRS or complete an Installment Agreement Request. Individuals do not need to wait for a tax bill to request an Online Payment Agreement. The monthly payments to the IRS can be extended over a 72-month period and taxpayers do not have to disclose their financial information to the IRS. Businesses with a total balance due below $25,000 can also request a monthly payment plan. Any taxpayer owing taxes should consider an installment plan as it can reduce penalties.
Individuals with a total balance due less than $100,000 can request short-term payment plans with the IRS allowing them to full pay the balance due within 180 days or less.
Individuals with balances above $50,000 (up to $1 million) can also submit an Installment Agreement Request. However, they must also submit a Collection Information Statement requiring financial disclosures related to assets, equity, income, and expenses.
Individuals owing more than $1 million will be assigned an IRS Revenue Officer who will analyze the taxpayer’s ability to pay their tax liability. Revenue Officers generally require a Collection Information Statement with supporting documentation.
For taxpayers planning to extend their 2022 tax filings, extension payments made in April may need to take into account additional tax liabilities related to amortized Section 174 expenditures. Taxpayers neglecting to do so may be subject to interest and penalties.
If the required extension payment can’t be made in full, it is too early to formally negotiate a payment arrangement with the IRS. In these cases, it is best to make multiple payments to the IRS. Once the return is completed (by the extension due date), reporting a balance due, payment alternatives can be considered.
Generally, the ability to currently deduct R&E expenses is viewed as an incentive to keep jobs in the U.S., and there is broad support for legislation that would either repeal or delay the changes to Section 174.
However, it is currently unknown whether there will be a law change and whether the change would be retroactively effective to January 1, 2022. Affected taxpayers may consider contacting their Congressional representation to highlight the impact of these changes to Section 174 and the need for Congressional action.
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This article is provided for general informational purposes only. It is not legal, accounting or other professional advice, as it does not address any individual facts, circumstances or concerns. Before making personal or business related decisions, please consult with appropriate legal, accounting or other qualified professionals.
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