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Innovation has long been the driving force behind progress, but sometimes progress becomes bogged down in a tangle of red tape. Such is the terrain of Research and Development (“R&D”) tax deductions and credits. The complexity of the credits has long placed them in the spotlight of IRS examiners. And as of 2022, those intricacies have been compounded by the implementation of new rules requiring potential R&D expenditures to be evaluated and frequently capitalized. These changes to IRS Code Section 174, made by the Tax Cuts and Jobs Act of 2017 (TCJA), mandate businesses to capitalize and amortize their R&D expenses over five years for domestic activities and a period of 15 years for overseas endeavors.
In light of the economic turbulence precipitated by COVID-19 and various other global trends, there has been a sustained partisan push in Congress to postpone the implementation of the new rules. This shared objective has led to the IRS deferring the proposal of new regulations pertaining to the law. However, despite the IRS’s anticipation of Congress passing this delay, the due date for 2022 taxes has been surpassed and the extended deadline for millions of affected returns is fast approaching.
Taxpayers are left in a quandary. With the IRS stressing the importance of taxpayers' compliance, a fog of uncertainty blankets the landscape, intensified by the absence of any official guidance on R&D capitalization from the IRS.
Now, companies will have to find a way to navigate this unfamiliar terrain on their own.
A Look at the Uncertainty
Tackling the evolving terrain of tax law can be a daunting task for any financial leader, but the intricacies of Section 174 changes, in particular, have left many taxpayers scratching their heads in frustration. The biggest concern on everyone's mind is which R&D costs should be capitalized, especially when dealing with pay-rolled R&D teams or managers. While it's easy to determine when you've paid an R&D firm for their services, the situation becomes murkier when figuring out which in-house costs should be included for capitalization.
However, in addition to direct costs, it’s important to consider indirect costs. These indirect costs—often known as mixed service costs—must also be capitalized. According to the Treasury Regulations associated with Section 174, research or experimental expenditures applies to all “costs incident to the development or improvement of a product,” including the costs of obtaining a patent. While the Section 174 Treasure Regulations do not provide an official and comprehensive list of expenditures, they do provide examples of potentially qualifying research and development expenses. Those include:
- Heat, light, and power
- Laboratory materials
- Attorneys’ fees
- Applicable depreciation on a building used in connection with a specific research project
The absence of specific guidelines exacerbates the challenges associated with these new requirements, leaving companies in confusion regarding the scope and boundaries of capitalization. Without official IRS guidance, companies will have to rely on their own discretion to determine which costs should be capitalized and subsequently amortized. This decision-making process hinges upon the company's individual circumstances and its inclination toward a more assertive or conservative approach.
Will Guidance Be Issued?
Amidst the backdrop of recent bipartisan consensus in Congress advocating for the restoration of complete R&D expensing for a few more years or permanently, the prospect of deferring or eliminating the alterations to Section 174 seems elusive for the time being. Furthermore, the eagerly awaited release of IRS guidance is expected to be a matter of several months. As a result, taxpayers find themselves poised to navigate the upcoming filing of their 2022 tax returns, with unanswered questions lingering in the air.Eventually, guidance will be developed, and the uncertainty will be largely eliminated. The only question is when.
Working with a Professional
Due to the prevailing uncertainty and intricate nature of the modifications to Section 174, it is crucial to engage the services of a tax professional when pursuing the R&D credit. Doing so mitigates disruptions and optimizes tax strategy, maximizing credits and deductions tailored to your distinct circumstances. Moreover, this proactive step enhances accuracy when official guidance remains uncertain.
It is best to take a reasonably objective assessment of direct and indirect R&D expenditures. Consider all direct costs and then determine potential indirect costs. With no direct guidance, there is hope for some flexibility in deciding to capitalize indirect costs before official regulations or guidance is more established.
At CBIZ, we boast a team of seasoned R&D tax specialists who are well-equipped to cater to your specific requirements. Reach out to us today and let us assist you in navigating this complex landscape with confidence and expertise.
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