How Changes to R&D Expensing in 2022 Affect Your Business
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There’s no doubt about it. Research and development (R&D) is a necessary component for every business. It not only allows companies to stay ahead of their competitors–but, more importantly–it enables them to learn more about the demands of the market, and what they can do to improve their products and services. R&D plays a pivotal role in brand differentiation, and makes significant contributions to the bottom line.
Changes to R&D Expensing in 2022
The Tax Cuts and Jobs Act (TCJA) amended the tax treatment of R&D expenses effective for tax years beginning after December 31, 2021. This change means that for the 2022 tax year (happening right now), companies must capitalize their R&D expenses incurred in the U.S. and deduct them over a five-year period, versus expensing all R&D costs in the year it was incurred (prior treatment). R&D activities that are performed internationally must be capitalized and deducted over a 15-year period.
Here’s an example of how the capitalization rules and 5-year amortization would impact a company’s tax liability.
A startup tech company generates $500,000 in income annually from the sale of existing software. The company has $200,000 in non-R&D expenses annually. The company hires developers in 2022 to develop a new software, and incurs $500,000 in qualifying R&D expenses. For the 2022 tax year, the company must capitalize and amortize the $500,000 of R&D costs over 5 years.
As the above table illustrates, without R&D capitalization, the company would have a tax loss, and not owe income taxes for the year. With R&D capitalization under the same facts however, the company would report taxable income, requiring a significant tax payment to the IRS and relevant state tax authorities.
R&D Expensing Before TCJA
Prior to TCJA, companies could choose different ways to treat their R&D expenses for federal income tax purposes. Some of the most common practices were immediately deducting expenses the same year they were incurred, or amortizing them over a five-year period. This gave businesses the flexibility to either use the deductions immediately, or defer them, depending on which situation proved to be most beneficial to their finances and growth.
These options were more preferential for businesses because it allowed them to minimize tax liability and to defer taxes into the future as much as possible.
Now, companies will need to amortize their R&D expenses over 5 or 15 years, which may result in higher tax liabilities for companies that are profitable. For companies that are unprofitable, they may flip to a taxable income position, and may still have a tax liability for the 2022 tax year and onwards.
Why are these changes happening?
The 2017 Tax Cuts and Jobs Act made several large changes to business taxes on a permanent basis. Many of the other business tax changes were temporary or scheduled to change over the ensuing decade. There is speculation that the reasons for these changes are associated with reducing the budget deficit impact of the bill.
Is there a chance these R&D expensing amendments will be repealed or deferred?
The decision to do so remains uncertain. There have been numerous attempts to halt these changes in Congress–most recently under President Biden’s Build Back Better Act, which proposed to repeal the changes as well as delay the amortization rule until 2026. As of today, the passage of this legislation has been stalled in the senate.
However, many business owners across multiple industries, as well as tax firm professionals, are optimistic that these amendments will be repealed or deferred since it’s prohibitive to American R&D growth. Hopes remain high amongst many companies where R&D is imperative to success that Congress will implement a workaround to delay these changes, if not eliminate them altogether.
More information regarding whether or not these changes will be repealed or deferred will be made available in the coming months. In the meantime, it’s imperative that all businesses treat these changes as though they’re here to stay.
What can I do to ensure my business is ready for the changes related to R&D Expense Capitalization?
In the event that there is no legislative fix in 2022, here’s what you can do to ensure your business is ready for the R&D expensing changes for the 2022 tax year.
1. Cash flow planning. If your company has historically been unprofitable and has not paid income taxes, it may now be in a taxable income position as a result of 2022 R&D capitalization requirements.
If your company has been paying income taxes, its 2022 tax year (and beyond) liability may be significantly higher than that of prior years.
In both cases, it’s important to start planning your cash flow now to ensure you have cash on hand to make any income tax payments as a result of this tax law change.
2. Documentation. This tax law change will also increase your company’s administrative burden. You will need to track your company’s R&D expenses carefully each year they are incurred, and then capitalize them over five years. Having sufficient documentation of each expense as they occur may seem tedious in the beginning, but organization of this information will be beneficial (and needed) in the long run for ease of reference and record-keeping for every tax year.
3. Partner with an R&D Tax Credit Provider. Understanding how the R&D tax credit works can be nuanced and overwhelming. Especially now that expensing changes are being thrown into the mix. When filing for the R&D credit, partner with a top-tier tax preparer to ensure you do it correctly to avoid potential fines, penalties, and audits.
Unsure how to navigate these changes? We can help.
At Pilot, our tax experts take care of all the heavy lifting so you don’t have to. Speak to an expert today to learn more about the changes to R&D expensing, and how we can help your business navigate these changes for the 2022 tax year and beyond.