R&D Tax Credit Changes – What Taxpayers Need to Know

The Research & Development (R&D) tax credit can provide significant savings to businesses conducting eligible activities. It has become an attractive tax incentive as over the last 15 years the number of companies claiming the credit has almost doubled. It may come as no surprise that the opportunity to deduct eligible expenses in the year incurred is one compelling reason. Unfortunately, changes made in the Tax Cuts and Jobs Act (TCJA) now require eligible research expenses claimed under Section 174 need to be capitalized and amortized. In other words, taxpayers can no longer capture immediate savings. Concurrently, businesses are also required to make a change of accounting method to comply with these new rules. To help clients, prospects, and others, Wilson Lewis has provided a summary of the key details below.

R&D Tax Credits – What Changed?

Under prior regulations, businesses were permitted to decide whether to immediately deduct eligible research expenses, amortize over a five-year period, or elect a longer ten-year period. The TJCA changed this for tax years after December 31, 2021, to require eligible expenses to be capitalized and amortized over a five or fifteen-year period. The shorter number applies to eligible expenses incurred on domestic projects while the other pertains to foreign R&D efforts.

As outlined in IRS Revenue Procedure 2023-11, amortization starts “with the midpoint of the taxable year in which such expenditures are paid or incurred.”  This means that only 10% can be amortized in the first year, 20% over the next four years, and 10% in the final year.

Accounting Method Change

Since compliance with the new regulations requires a change in accounting method, the IRS has issued an automatic process that does not require the submission of IRS Form 3115, Application for Change in Accounting Method. Rather the company must submit a statement with the annual income tax return which includes the following information:

• Name and Employer Identification Number of the business.
• Beginning and end dates of the first taxable year in which the required change takes effect.
• A description of the type of expenses included as specific research or experimental expenditures.
• The amount of expenses paid or incurred by the applicant during the year of change.
• A declaration that the applicant is changing accounting methods to capitalize eligible expenses and amortize over the appropriate five or fifteen-year period beginning with the mid-point of the taxable year in which expenses are paid. It is important to note the declaration must also include a statement that the change is being made on a cut-off basis.

For those making the change after the first taxable year after December 31, 2021, a business must include the following information along with IRS Form 3115, including:

• A description of the type of expenses included as specified research or experimental expenses.
• The taxable years in which eligible expenses subject to the change were paid or incurred.
• A declaration the applicant is changing accounting methods for the purpose of complying with the new requirements. It should be stated the business will amortize expenses over the required five- or fifteen-year period starting at the mid-point of the taxable year.
• A declaration the company is making the change with a modified 481(a) adjustment that takes into account only specified research or experimental expenditures paid or incurred in taxable years beginning after December 31, 2021.

Differences Between Sections 41 and 174

If a business previously applied for an R&D tax credit under Section 41, there may be questions about the differences between Section 41 and 174 credit. Specifically, whether claiming the credit under Section 41 offers better tax savings. While complicated, there are key differences between the two options, and applying under Section 41 does not mean it will be possible to avoid the amortization requirement.

When weighing options with which section applies, it’s important to remember that if a research expenditure applies under Section 41, it also applies to Section 174. However, this is not always the case the other way around. Qualified research activities that are entitled to an R&D tax credit under Section 41 are narrower.

Entities can qualify for the R&D tax credit, as defined by Section 41 if they pass the four-part test:

• Meeting the permitted purpose of R&D activity
• Eliminating uncertainty around development or improvement
• Having a proper process of experimentation
• Discovering information based in technology.

Once R&D activities exceed a calculated base amount, the credit applies to 20% of qualified expenses, or taxpayers can take an alternative simplified credit (ASC) of 14% of qualified research expenses (QREs) beyond a base amount.

It’s important to remember that many expenses may fall outside of Section 41 but apply to Section 174, meaning avoiding the amortization requirement may not be possible.

Contact Us

The changes to the federal R&D tax credit mean many companies will have to wait to realize the full savings potential. For those expecting to immediately deduct expenses, it is certainly unwelcome news. Since the R&D credit is complicated, consulting with a qualified tax advisor is important to determine how you will be impacted. If you have questions about the information outlined above or need assistance with a tax or accounting issue, Wilson Lewis can help. For additional information call 770-476-1004 or click here to contact us. We look forward to speaking with you soon.