The Tax Cuts and Jobs Act signed into law on 12/22/2017 creates a significant change for research expenditures defined under section 174, which are expenditures that represent a research and development cost in the experimental or laboratory sense and are connected to the taxpayer’s trade or business. This section is considered the “Technical Uncertainty” portion of the 4 Part Test that defines qualified research under section 41(d), meaning that any cost considered for the R&D Credit must first be classified as a section 174 expense. For tax years beginning after 12/31/2021, incurred research expenditures under section 174 must be capitalized instead of expensed. Qualified expenditures will be amortized over 5 years using the half-year depreciation convention. Foreign research that is conducted on behalf of the taxpayer will be amortized over 15 years, but will still be ineligible for inclusion in the section 41 R&D Credit. This change from research expenses to capitalized expenditures will also require a change of accounting method for purposes of Section 481.
This change will be most impactful for small- and medium-sized companies that claim the R&D credit and utilize the Activities Approach in junction with the Cohan Rule to estimate their expenses. Using this method, taxpayers typically group their qualified research expenses (QREs) with other expenses without differentiation, such as keeping their wage QREs combined with the rest of their wage expenses. Under the new law, companies will need to identify and separate the section 174 expenditures that will be amortized, necessitating a more in-depth accounting analysis. While this may seem burdensome, isolating these expenditures in separate accounts should help in audit defense situations. Fortunately, companies have 5 years to prepare for this change and further guidance from the IRS is expected to be forthcoming. Furthermore, we at McGuire Sponsel predict the section 174 amortization requirement will be adjusted or eliminated before 2022 due to the burden it could create for taxpayers.
Another implication of the Tax Cuts and Jobs Act applies to tax years 2018 and beyond; taxpayers who claim the R&D credit on Form 6765 and elect the 280C on their originally filed returns will now reduce the credit by 79% instead of 65% to yield the effective credit in accordance with 280C(c)(3)(B)(ii)(II). This is due to the reduction of the highest corporate tax rate from 35% to 21%.