New for 2022: businesses can’t deduct their R&D or software development spending all at once.
by Michael Cieri, CPA
Research and development are significant parts of spending by innovative businesses. For many years these costs have enjoyed tax favored treatment, expensed in the year the cost was incurred, with additional valuable federal and state tax credits for certain categories of research spending.
After 2021, research expenditures cannot be deducted in the year paid or incurred. Instead, the costs are added to the balance sheet and amortized over a six-year period – 16 years for foreign research spending. Costs connected with development of any software are treated as research expenditures. A company writing software code might not think it was doing R&D but nonetheless get caught in this new rule.
Research expenses may include more than what is eligible for the research credit. Research expenses include all expenses related to the development or improvement of a product or the development of computer software. This includes costs of obtaining a patent, such as attorney’s fees. Other costs that are generally considered research expenses are wages, subcontractors, supplies and software services. It used to be a taxpayer would seek to characterize a borderline cost as deductible R&D. This is no longer the case as taxpayers will want to ensure they don’t erroneously characterize a cost that could be currently deducted as a research expense that must be amortized. Taxpayers should work with their tax advisors to ensure expenses are accounted for properly.
Not all states automatically conform to changes in federal tax. Taxpayers will need to consider the effect, if any, of this change on their state tax liability.
These changes do not impact the GAAP accounting treatment of R&D expenses. If your company keeps accounting statements on a GAAP basis this may cause significant book to tax timing differences.
The change in tax treatment could have substantial tax implications for companies with losses that spend significantly on research or software development. Some companies could have unexpected taxable profits. Imagine an early-stage company with $300,000 in revenue that spends $400,000 on research. On the books, it will show a loss of $100,000. But for tax, only 1/10th, or $40,000, of the $400,000 research spending is deductible in the first year of amortization. The company will have taxable income of $260,000 – this, even though it may have spent all its cash.
Eventually, the entire research spend will be expensed. After several years, the distortion caused by the new provision should recede.
The research tax credit is not impacted by this change. If an expenditure could generate a credit, the taxpayer will be better off claiming the credit than foregoing it, even with this adverse new rule.
As this provision in the law is not considered taxpayer friendly, this is something that could always be repealed by a pro-business Congress. Taxpayers and their advisors will need to watch developments in Washington closely. Affected taxpayers may want to contact their elected representatives to advocate for a change in this law.
John Schachter + Associates helps clients plan for the tax impact of research amortization. Please ask us if we can help your company navigate these changes.
