Why is this important? Before 2022, companies could deduct the total cost of R&D (also called research and expenditure in the tax code) on their tax returns. The 2017 Tax Cuts and Jobs Act stopped this practice.
As of January 1, 2022, companies must capitalize and amortize the cost of research and development–including software development costs.
Instead of immediately deducting R&D expenses in the same fiscal period, you must spread them out over five or fifteen years. Five years are required for R&D expenses incurred within the U.S.
The generally recognized accounting principles remain the same. R&D expenses will continue to appear in financial statements.
How Does R&D Capitalization Work
Let’s look at an example to understand R&D capitalization better.
Imagine a company with a $1 million revenue. R&D costs for a new product are $1.5 million. Before the 2017 TCJA, their R&D expenses would have resulted in a $500,000 loss in tax, and no tax was paid.
The $1.5 million in R&D expenses must be capitalized and amortized for five years, starting with the tax year beginning after December 31, 2021 (assuming that costs were incurred in the U.S.). The $300,000 deduction is based on $1 million in tax revenue, translating to $700,000, with a federal rate of 21%, almost $150,000 in tax liability.
This company generated $1 million in revenue but spent $1.5 million. They lost money. They lost money.
You can see that the changes in R&D cost-capitalization result in an increase in phantom income. Amortization can cause companies to be taxable, even if they are at a loss. Some companies with high R&D investments and no taxable revenue may struggle to raise funds necessary to pay the new income tax resulting in the TCJA.
The federal tax code is a constantly changing beast. We recommend you consult a tax expert for more information about how capitalizing development costs will affect your business.
How to reduce the impact of R&D Capitalization
It’s not all bad news. You can offset some of the TCJA’s effects. The R&D credit is the answer.
The capitalization changes made in January 2022 will not affect the R&D credit. Two different IRS code sections govern R&D capitalization.
In the 1980s, Congress created the federal R&D credit. The credit was designed to reward and incentivize companies who kept their R&D activities in the U.S.
If you are a traditional taxpayer with federal income, the R&D credit will reduce your federal income taxes dollar for dollar. If you are a small business that has yet to reach $5 million in revenue, the R&D tax credit can be used to offset payroll taxes.
There are also R&D tax credits at the state level. About 30-35 states offer their R&D credits (this number changes each year depending on the state budget).
How to Benefit from the R&D Tax Credit
The R&D tax credit is no exception. IRS requires that companies claiming an R&D tax credit provide specific and detailed information regarding their eligibility.
Companies must at least identify all business components related to the R&D Credit for that particular year. These activities are referred to as QREs or qualified research expenses. Companies must:
Identify the R&D activities that you have performed
Identify the title or position of each R&D worker
Identify the information that each person sought to learn through R&D.
Companies can use the R&D 4-part test to ensure that activities are QREs. This test, at a high level, ensures that the activities are technological and designed to create new or improved business components. The companies faced technical uncertainty and had to experiment in order to develop this new business component. This credit is available if the associated activity meets all four criteria.
What R&D expenses can be capitalized
R&D expenses are defined broadly under Section174 as “all costs incidental to the development or improvements of a product or process, technique or formula, invention or patent or other similar property”.
Examples include:
The cost of obtaining a Patent
Software development costs
Materials
Depreciation
Wages
Overhead
R&D costs include costs related to the improvement or development of a new product, regardless of whether it is intended to be sold or used internally.
The following expenses are not included in Section 174:
Buying an existing patent or model, product, process, or production
Land or other depreciable assets can be acquired or improved.
Acquiring depletable property
Exploration for oil or gas
Testing or Quality Control
Survey on consumer or efficiency
Management Study
Advertisement or Promotion
Research for literary, historic, or similar projects
How Pluralsight can streamline R&D costs reporting
It’s not easy to document where all your R&D expenses are spent. Pluralsight Flow Investment profile is designed to assist companies in capitalizing their R&D costs. The tool allows organizations to visualize where their resources and time is going.
Investment Profile is automatically configured so that you can review historical data and better understand previous investments. It’s fully customizable to suit your needs.
