If your business qualifies for the research and experimentation (R&E) tax credits, it’s important to know that changes to the tax treatment of R&E expenditures will go into effect on January 1, 2022. The Tax Cuts and Jobs Act (TCJA) of 2017 set the timing for these changes – here’s how they may affect your business:

Research & Experimentation Tax Credits

The TCJA did not make substantive amendments to Section 41, Credit for Increasing Research Activities, however, it modified Section 41(d)(1)(A) to conform Section 41 to the amendments made to Section 174. Under the Tax Cuts and Jobs Act (TCJA), for amounts paid or incurred in tax years beginning after 2021,[1] qualifying research expenses must be “specified research or experimental expenditures” under IRC § 174 — R&E expenditures which are paid or incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.[2]

This means that a taxpayer could not claim the research credit and deduct the Section 174 research expense as the cost of goods sold (COGS). The expense is either COGS and, thus, not a specified R&E expenditure, so it does not qualify for the research credit, or it is a specified R&E expenditure and must be capitalized and amortized over five years to claim the research credit. Taxpayers would thus need to calculate the relative benefits of both positions (an immediate deduction as opposed to a research credit and a deduction spread over five years).

Section 174: Tax amortization of research or experimental expenditures

Under TCJA, for amounts paid or incurred in tax years beginning after Dec. 31, 2021, taxpayers will have to charge their specified R & E expenditures to capital account and will be allowed an amortization deduction of the expenditures ratably over the five-year period beginning with the midpoint of the tax year in which the expenditures are paid or incurred.[3] The term ‘specified research or experimental expenditures’ means research or experimental expenditures which are paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business, which represent research and development costs in the experimental or laboratory sense. The term generally includes all such costs incident to the development or improvement of a product, and research costs for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.

Software development costs

Additionally, TCJA specifically requires any software development costs to be treated as research or experimental expenditures under Section 174. Under TCJA, capitalized research or experimental expenditures that relate to property that is disposed of, retired or abandoned during the amortization period will continue to be amortized for the duration of the amortization period.

Currently, for amounts paid or incurred in tax years beginning before Jan. 1, 2022, under Code Sec. 174, taxpayers can deduct research or experimental (R & E) costs as current expenses or capitalize and amortize those costs over no less than 60 months. Alternatively, taxpayers may elect to amortize their research expenditures over 10 years under Section 59(e). If costs are capitalized, a loss deduction may be permitted if the project proves unsuccessful and is abandoned.

Help with R&E Credits

Have a question about R&E credit eligibility, or how to prepare for the upcoming changes? Contact us for a free consultation with a member of our research & experimentation credits team. We’re here to help.

[1] Sec. 13206(e), PL 115-97, 12/22/2017.

[2] IRC § 174(b), as amended by Sec. 13206(a), PL 115-97, 12/22/2017.

[3] IRC § 41(d)(1).