R&D Tax Change Spells Delayed Savings

The federal Research and Development (R&D) tax credit not only encourages innovation but provides a significant tax saving opportunity. For many, the credit is so attractive because of the opportunity to deduct eligible expenses incurred as part of a project. When combined with the state-level saving opportunities, offered in both New Jersey and Pennsylvania, it is easy to understand the appeal of this lucrative credit. The state version of the credit can be applied to reduce state income taxes or, in the case of Pennsylvania, can also be assigned or sold to other companies.

Despite the savings potential, a recently enacted change implemented as part of the Tax Cuts and Jobs Act (TCJA) will mean delayed savings. For tax years starting after December 31, 2021, taxpayers claiming the R&D credit under IRC Section 174 (§174) will be required to amortize eligible expenses over a 5-year period, rather than taking an immediate deduction. In the event the costs were incurred on foreign projects, the amortization period increases to 15 years. This change means businesses will not have immediate access to expected savings. To help clients, prospects, and others, Klatzkin has provided a summary of the key details below.

What did the TCJA Change?

It changed the regulations permitting companies to deduct eligible R&D expenses and now requires the taxpayer to charge the expenses to a capital account and amortize the amount over a 5 or, in certain cases, a 15-year period. Previously, taxpayers were allowed to either deduct eligible expenses, capitalize, and amortize over a five-year period or elect a 10-year amortization schedule.

As outlined in IRS Revenue Procedure 2023-11, amortization starts “with the midpoint of the taxable year in which such expenditures are paid or incurred.”  This means that only 10% can be amortized in the year the expense was incurred, then 20% over the next four years, and finally 10% in the final year.

Change in Accounting Method

Amortizing qualified expenses, rather than deducting, requires a company to make a change in its accounting method. This typically requires the submission of IRS Form 3115, Application for Change in Accounting Method. However, the IRS has outlined automatic procedures for those seeking a change to comply with the new regulations. It is important to note the automatic method only applies to the first taxable year after December 31, 2021. Under these rules, taxpayers simply need to submit a statement with the tax return for the first taxable year the new rules go into effect. The statement should include the following information:

• Name and Employer Identification of the business.
• Beginning and end dates of the first taxable year in which the required change takes effect.
• A description of the type of expenses included as specific research or experimental expenditures.
• The number of expenses paid or incurred by the applicant during the year of change.
• A declaration that the applicant is changing accounting methods to capitalize eligible expenses and amortize over the appropriate 5- or 15-year period beginning with the mid-point of the taxable year in which expenses are paid. It is important to note the declaration must also include a statement that the change is being made on a cut-off basis.

For those seeking to change after the first taxable year, the IRS requires that Form 3115 be submitted. A taxpayer submission should include a statement with the following information:

• A description of the type of expenses included as specified research or experimental expenditures.
• The taxable year in which eligible expenses subject to the change were incurred.
• A declaration that the applicant is changing accounting methods to capitalize eligible expenses and amortize over the appropriate 5- or 15-year period beginning with the mid-point of the taxable year in which expenses are paid. There must also be a statement indicating only eligible expenses incurred in taxable year beginning after December 31, 2021, are included.

Contact Us

The changes to the rules governing R&D tax credits taken under IRC Section 74 are complicated. The inability to deduct R&D expenses in the year incurred means taxpayers will not be able to immediately receive the tax benefit. For this reason, it is important to consult with a qualified tax advisor to determine how you will be impacted. If you have questions about the information outlined above or need assistance with a tax or accounting issue, Klatzkin can help. For additional information call 609-890-9189 or click here to contact us. We look forward to speaking with you soon.

©2023 Klatzkin & Company LLP. The above represents our best understanding and interpretation of the material covered as of this post’s date and should not be construed as accounting, tax, or financial advice. Please consult your tax advisor concerning your specific situation.