Changes to the tax treatment of research expenditures are having a big impact on many manufacturers’ tax bills. For calendar-year taxpayers, the impact date is Sept. 15, 2023. This change took effect in 2022 pursuant to the Tax Cuts and Jobs Act (TCJA). It requires businesses to capitalize research and experimental (R&E) expenditures under IRS Section 174 and amortize them over five years (15 years for research conducted outside the United States). Previously, businesses had the option to immediately deduct these expenditures. Given the potential impact of these lost deductions, manufacturers should conduct a study of their research expenditures and consider strategies for reducing their tax bills.
Revisit the R&D Credit
One potential tax-saving option is to determine whether R&E expenditures qualify for the credit under Section 41 for “increasing research activities” (commonly referred to as the R&D credit). Tax credits are generally more valuable than tax deductions. While both save taxes, tax deductions lower your taxable income, but tax credits reduce your tax bill dollar for dollar.
Note that the Inflation Reduction Act (IRA) of 2022 expanded the ability of start-up businesses to use R&D credits to offset payroll tax liability. The TCJA allowed start-ups — generally defined as companies that are less than five years old and have less than $5 million in gross receipts — to claim R&D credits against up to $250,000 in Social Security tax liability. The IRA allows these businesses to claim up to an additional $250,000 against their Medicare tax liability.
Keep in mind that not all R&E expenditures will qualify for the R&D credit. Section 174 applies to a broad range of expenditures, including both direct and indirect R&E expenses. In contrast, Section 41 is generally limited to only direct expenses.
Analyze our R&E Expenditures
Another option is to conduct a study of your R&E expenditures to determine whether any of them can be properly reclassified as deductible business expenses under Section 162. Prior to the TCJA’s 2022 change, businesses didn’t need to worry too much about whether expenses were deductible under Section 174 or Section 162, because the tax treatment was essentially the same. Now, however, determining the proper classification of expenses can mean the difference between capitalizing them or deducting them immediately.
As you review these expenses, keep in mind that under the TCJA, to be eligible for the R&D credit, an expense must be treated as an R&E expenditure pursuant to Section 174. So, it’s important to weigh the potential benefits of reclassifying R&E expenses as deductible business expenses against the potential loss of R&D credits.
Consider Purchasing Software
Another significant change made by the TCJA was to change the tax treatment of software development costs. Previously, taxpayers had the option of deducting these costs as they were paid or incurred.
Now, however, software development costs are treated as R&E expenditures required to be capitalized and amortized under Section 174. A potential strategy for softening the tax blow of this change is to purchase software, which is deductible immediately as a business expense, rather than to develop it in-house.
The requirement to capitalize and amortize R&E costs can have a significant tax impact on certain manufacturers. Be sure to work with a trusted tax advisor to help you navigate through these new rules and ensure you’re claiming this appropriately. Contact our manufacturing CPAs today to obtain assistance.