The law known as the Tax Cuts and Jobs Act of 2017 (TCJA), P.L. 115–97, made a great number of modifications to the Code. Many of these changes may prove beneficial for taxpayers claiming the credit for increasing research activities under Sec. 41 (the research and development (R&D) tax credit). Nonetheless, taxpayers should also be aware of the TCJA's delayed effective date for an amendment to Sec. 174(a), which now permits research or experimental expenditures to be deducted currently, to one where, beginning in 2022, Sec. 174 expenses must be amortized. There is also a corresponding change to Sec. 41 to align the provisions.
While many believe that Congress may eliminate these modifications before they take effect, the current political environment, coupled with changes in congressional leadership as a result of the recent election, may not foster the legislative cooperation needed to make those changes possible.
This article first identifies key changes the TCJA made to the Code, which will indirectly affect taxpayers' R&D tax credit claims. It then discusses the modifications the TCJA made to Sec. 174, as well as corresponding changes to Sec. 41, which will affect taxpayers' R&D tax credit claims for tax years beginning after Dec. 31, 2021. Taxpayers should understand the impact of these changes now, as they may affect planning of research and development in tax years beginning before Jan. 1, 2022.
Tax code changes indirectly affecting the R&D tax credit
Since the TCJA was signed into law on Dec. 22, 2017, a significant amount of discussion has focused on the changes to the corporate and individual tax rates. Specifically, the TCJA simplified the corporate tax rate by eliminating the tiered rate structure based on taxable income and provided a single 21% corporate tax rate under Sec. 11(b), and modified individual tax rates, setting the top individual tax rate at 37%. Although the corporate rate changes are permanent, the modified individual tax rates are only effective for tax years beginning after Dec. 31, 2017, and ending before Jan. 1, 2026. While the tax rate changes may reduce some taxpayers' income tax liability, the modification of the corporate tax rate also increased the value of the R&D tax credit that corporate and noncorporate taxpayers may claim when electing to claim a reduced credit.
For tax years beginning before Jan. 1, 2022, Sec. 280C(c)(1) provides that no deduction is allowed for that portion of qualified research expenses otherwise allowable as a deduction for the tax year that is equal to the amount of the credit determined under Sec. 41(a). However, taxpayers may elect to claim a reduced credit under Sec. 280C(c)(3), which eliminates the need for taxpayers to make such a modification to taxable income. Before the TCJA, taxpayers had to reduce the amount of the credit by the maximum tax rate under former Sec. 11(b)(1), which was 35%. As a result, taxpayers claiming the reduced credit only recognized a tax credit benefit that equated to 65% of the credit determined under Sec. 41(a). Following the TCJA, taxpayers must reduce claimed credits by only 21%, as provided under amended Sec. 11(b), and thus will recognize a benefit that equates to 79% of the credit determined under Sec. 41(a).
The TCJA also expanded the availability of the R&D tax credit for certain taxpayers. For corporate taxpayers, it eliminated the Sec. 55 alternative minimum tax (AMT) and amended Sec. 38(c)(6) to treat a corporation as having zero tentative minimum tax. These amendments removed a hurdle that previously prevented some corporate taxpayers from using credits determined under Sec. 41(a), due to the Sec. 38(c) tentative minimum tax limitation. (The Protecting Americans From Tax Hikes Act of 2015, P.L. 114-113, had already eliminated this limitation for corporate and noncorporate taxpayers with average annual gross receipts of $25 million or less for the three tax years preceding the tax year, since the R&D tax credit is considered an eligible small business tax credit for these taxpayers.)
For tax years beginning after Dec. 31, 2017, corporate taxpayers will remain subject to a credit limitation that specifies that a credit cannot exceed the excess of the taxpayer's net income tax over 25% of the taxpayer's net regular tax liability above $25,000 (Sec. 38(c)(1)).
For individual taxpayers, the TCJA increased the AMT exemption, as well as the phaseout amount, for tax years beginning after Dec. 31, 2017, until 2026. These changes, coupled with the new Sec. 164(b)(6) limitation on deducting state and local taxes, a preference item for AMT purposes, may provide noncorporate taxpayers additional ability to use the credit.
For all taxpayers, the TCJA amended Sec. 172(a) for tax years beginning after Dec. 31, 2017, by adding a new limitation on the use of net operating losses (NOLs) that restricts their use to the lesser of the aggregate of these losses carried to the tax year plus the NOL carrybacks to the tax year, or 80% of taxable income. The TCJA also eliminated the carryback of NOLs and made the carryforward of those losses indefinite under Sec. 172(b). The new 80% taxable income limitation may require some taxpayers to seek additional tax savings opportunities, such as the R&D tax credit, which they did not need to address prior to the tax law change. The NOL limitation is effective only for those losses generated in tax years beginning after Dec. 31, 2017, so taxpayers will have full use of carryforward NOLs generated in earlier tax years.
Noncorporate taxpayers may also have additional capacity to use up NOLs due to the Sec. 461(l) limitation on the deductibility of excess business losses for tax years beginning after Dec. 31, 2017, until 2026 (Section 11012 of the TCJA).
These changes to the Code provide opportunities for taxpayers that may have overlooked the R&D tax credit in prior tax years to reconsider the credit to reduce income tax liability. However, while taxpayers may focus on these changes taking place in the present tax year, they should also evaluate the potential impact of modifications taking effect for tax years beginning after Dec. 31, 2021.
Modifications to Sec. 174
Pre-TCJA, Sec. 174 provided taxpayers with the option of immediately expensing R&D expenditures under Sec. 174(a) or electing under Sec. 174(b) to treat these expenditures as deferred expenses and amortize the costs over a period of not less than 60 months beginning with the month that the taxpayer first realizes benefits from those expenditures. In addition, under Sec. 174(f)(2), taxpayers could elect under Sec. 59(e) to amortize over 10 years expenditures otherwise allowed as a deduction under Sec. 174(a).
Taxpayers that paid or incurred expenses for software development could also rely on Rev. Proc. 2000-50. Due to the similarity of those expenditures with those identified under Sec. 174, the revenue procedure provides that the IRS will not disturb a taxpayer's treatment of these costs if consistently deducted in full in accordance with rules similar to those under Sec. 174(a) or consistently capitalized and recovered through amortization deductions under rules similar to those under Sec. 174(b).
Following the TCJA, the current accounting methods under Sec. 174 and Rev. Proc. 2000-50 remain the same for tax years beginning before Jan. 1, 2022, but, for tax years beginning after Dec. 31, 2021, the TCJA eliminates the option to deduct R&D expenditures currently and requires taxpayers to charge them to a capital account and amortize them over five tax years, beginning with the midpoint of the tax year in which the specified research or experimental expenditures are paid or incurred (Sec. 174(a), as amended by the TCJA). The ability to deduct an expenditure beginning with the midpoint of the tax year in which the specified R&D expenditure is paid or incurred is favorable compared to current Sec. 174(b), which does not allow a deduction until the first month that a taxpayer realizes benefits from R&D expenditures.
For foreign research, the amortization period is extended to 15 tax years. The amended Sec. 174 requires the extended amortization even in cases of a retired, abandoned, or disposed property for which specified research or experimental expenditures are paid or incurred, thereby denying an immediate deduction in the case of retirement, abandonment, or disposal (Sec. 174(d), as amended by the TCJA).
The TCJA also changed the language in section 174 from "research or experimental expenditures" to "specified research or experimental expenditures," and adds a special rule under Sec. 174(c)(3) that specifies that for purposes of Sec. 174, any amount paid or incurred in connection with the development of software is treated as a "specified research or experimental expenditure." As a result, the TCJA effectively eliminates taxpayers' ability to rely on Rev. Proc. 2000-50 to deduct software development expenditures.
The modifications for the 2022 tax year and beyond will require taxpayers to change accounting methods. Moreover, the accounting method change will be applied on a cutoff basis, and thus taxpayers will not have a Sec. 481(a) adjustment (Section 13206(b) of the TCJA). Taxpayers that have used Sec. 174(a) or Rev. Proc. 2000-50 to expense costs related to research or experimentation or software development, respectively, should consider the temporary timing difference that will result from the Sec. 174 modifications. In addition, due to the different amortization period requirements for domestic and foreign research or experimentation, taxpayers should reconsider the tax cost of performing R&D activities outside the United States.
How the Sec. 174 modifications change the R&D tax credit
Regardless of taxpayers' selection of accounting method for Sec. 174 expenditures, for purposes of the R&D tax credit, Sec. 41(d) defines "qualified research" in part as "research with respect to which expenditures may be treated as expenses under section 174." Currently, many taxpayers may claim expenditures for the R&D tax credit under Sec. 41 that they may deduct elsewhere on their tax return under Sec. 162 as an ordinary and necessary business expense.
Due to the present ability to expense and deduct expenditures in the current tax year under either Sec. 162 or Sec. 174(a), taxpayers' classification of expenditures may not raise significant concern. The exception would be for those passive owners of passthrough entities who pay AMT, and thus must amortize research or experimental expenditures under Sec. 59(e)(2) when not amortizing them under Sec. 174(b). However, once the modified language of Sec. 174 takes effect for tax years beginning after Dec. 31, 2021, then all taxpayers will have to consider the timing difference of a deduction under Sec. 174 as compared to Sec. 162.
The creation of the timing difference in classification of expenditures is a critical issue that taxpayers should consider when analyzing the R&D tax credit for tax years beginning after Dec. 31, 2021. Since the TCJA makes a corresponding amendment to Sec. 41(d)(1)(A) to define qualified research, in part, as "specified research or experimental expenditures under section 174," taxpayers will have to consider the impact to the timing of deductions if they pursue the credit. The IRS is more likely to analyze taxpayers' classification of expenditures for deductions, if they claim the R&D tax credit. Thus, taxpayers will have to validate the expenditures claimed as Sec. 41 expenditures as "specified research or experimental expenditures" under Sec. 174, and will have to amortize those costs over five tax years, or 15 tax years for foreign research.
R&D tax planning moving forward
Due to the delayed effective date of the modifications to Sec. 174 and Sec. 41, taxpayers have a window to continue to take advantage of the current expensing of research or experimental expenditures under Sec. 174(a), while also claiming a reduced credit under Sec. 280C that equates to 79% of the credit value. Consequently, taxpayers with planned R&D activities should consider expediting those expenditures to before 2022. To illustrate, for the 2018 tax year, a corporate taxpayer could currently expense $100,000 of research or experimental expenditures. If all the costs pertain to domestic research and development, the taxpayer may also claim a reduced R&D tax credit of approximately $5,530 (in the case where a taxpayer calculates the credit under the alternative simplified credit method and has incurred the same amount of domestic R&D expenses for the prior three tax years). If the taxpayer has full use of the tax credit, the corporate taxpayer would recognize $26,530 of tax savings for the tax year. However, the same $100,000 spent in 2022 may only yield a benefit of $7,630 with an additional $90,000 of amortization over the next five tax years.
Taxpayers should also evaluate the location of future R&D activities. The longer amortization period for foreign specified research or experimental expenditures may encourage taxpayers to move additional R&D activities into the United States. While taxpayers will need to evaluate the international tax aspects of this tax planning strategy, the domestic relocation of research and development would not only maintain the amortization period at five tax years (as opposed to 15), but would increase any potential R&D tax credit, since unlike Sec. 174, qualified research expenditures only qualify under Sec. 41 if they pertain to R&D activities performed in the United States.
It should be noted that the forced amortization of specified research or experimental expenditures may also provide additional tax planning opportunities, particularly for noncorporate taxpayers, during the window for tax years beginning after Dec. 31, 2021, and before Jan. 1, 2026. Due to the enactment of the new Sec. 199A, owners of passthrough entities may claim a 20% deduction of qualified business income for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026. The amortization of specified research or experimental expenditures may increase qualified business income, and thus increase the Sec. 199A deduction compared to a taxpayer that may have alternatively expensed research or experimental expenditures under the current version of Sec. 174(a). Moreover, if the individual tax rates revert to pre-2018 rates for tax years beginning after Dec. 31, 2025, the amortized research or experimental expenditures will decrease taxable income taxed at a higher tax rate.
Taxpayers need to act now
While taxpayers may be currently focused on tax rates and other modifications made to the Code by the TCJA, they need to consider changes to research or experimental expenditures beginning after 2021. Taxpayers should not count on these modifications never becoming law, but should analyze these issues now and consider expediting R&D activities to maximize the current deduction available under Sec. 174(a), while also enjoying the increased value of the reduced credit. Moreover, any planned relocation of future R&D activities from overseas to the United States may take years to implement. As a result, taxpayers should act now to maximize the tax benefits for R&D activities.
Daniel F. Laughlin, J.D., is a tax director at FGMK LLC in Chicago. For comments about this article or suggestions of topics for other articles, please contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.