Federal Income Tax Updates on R&D and Bonus Depreciation – What you Need to Know

Since 1954, companies engaged in research, experimentation and development (“R&D”) activities have been able to fully deduct their R&D expenses against their taxable income.  This treatment is allowed for qualified research expenses (“QRE”s) related to domestic and foreign research under Internal Revenue Code (“IRC”) Section 174.  QREs include: (1) wages and salaries of applicable research staff, (2) subcontract labor, (3) materials and supplies used in qualified research and (4) the costs of operating and maintaining research facilities (e.g., rent, utilities, insurance, etc.).  In addition to the deduction, many manufacturers also benefited from the R&D Tax Credit under IRC Section 41.

As part of the Tax Cuts and Jobs Act of 2017 (“TCJA”), certain tax deductions impacting manufacturers were slated to be curtailed with effective dates of 1/1/2022 and 1/1/2023.  Specifically, TCJA required capitalization and amortization (instead of immediate expensing) of R&D, including software development, costs and a reduction in “bonus” depreciation from 100% to only 80% the cost of eligible property.  Business advocacy groups lobbied hard to void or further delay those provisions and throughout 2022 there was widespread hope and expectation that the business community would prevail.  Unfortunately, the anticipated changes did not make it into any of the 2022 legislation.  Now manufacturers are left with a reckoning on these new rules.

For tax years beginning after Dec. 31, 2021, Section 174(a)(1) provides that specified research, development and experimental (“R&D”) expenditures are no longer currently deductible in the year paid or incurred. Instead, such expenditures must be capitalized to the balance sheet and amortized ratably over a five-year period (15-year period in the case of specified research or experimental expenditures attributable to foreign research – any research conducted outside the U.S., the Commonwealth of Puerto Rico or any possession of the U.S.) beginning with the midpoint of the taxable year in which such expenditures are paid or incurred. 

Software development costs are explicitly included as R&D costs and subject to the same rules effective 1/1/2022: capitalize and amortize over five years (or 15 years, if the costs are attributable to foreign development). Software development generally includes the design, coding, and testing of new or improved software. Contrast this treatment with “off-the-shelf” software, requiring little to no customization, software maintenance, training, or business process-related activities, and which can be amortized over 36 months or immediately expensed under either bonus depreciation or Section 179 rules beginning with the month the software is placed in service. The cost of leasing or renting software for use in the taxpayer’s trade or business is deductible as an ordinary business expense.

The IRS released procedures for taxpayers to change the treatment of R&D expenses. Revenue Procedure 2023-11 provides a method to obtain automatic consent under Section 446 to change methods of accounting for specified research or experimental, including software development, expenditures.  The change in method of accounting (from deduction to amortization) is made on a cutoff basis for any R&D expenditures paid or incurred in taxable years beginning after Dec. 31, 2021.  Using the cutoff method means only the items arising on or after the beginning of the year of the change are accounted for under the new method of accounting. If items arise before the year of change, such items continue to be accounted for under the former method of accounting.

The automatic change in method of accounting to comply with amended Section 174 is made by filing a statement with the taxpayer’s original federal income tax return for the first taxable year in which Section 174 becomes effective. The taxpayer is not required to file a Form 3115, Application for Change in Accounting Method, unless a change in the method to account for R&D expenses under Section 174 is made for a taxable year subsequent to the taxable year of the taxpayer in which Section 174 becomes effective.

Starting in 2023, small businesses can offset more of their R&D tax credits against their payroll taxes.  Instead of being limited to $250,000, eligible companies can opt to claim up to $500,000 of qualified research expenses to offset payroll taxes instead of income taxes.  This election is available to companies in business not more than five years and that have gross receipts of less than $5M.

Bonus depreciation under Section 168(k) allows the taxpayer to immediately expense qualified fixed asset additions, regardless of the taxable income of the company.  Effective 1/1/2023, instead of 100% of the cost of qualifying property being immediately expensed, only 80% of the cost can be.  The other 20% is eligible for depreciation under the depreciation rules discussed in IRC Sections 167 and 168.  Another 20% reduction will occur annually until the bonus depreciation rules are fully phased out as of 12/31/2026. Section 179 immediate expensing is still applicable but there are caps to the total amount written off ($1,080,000 in 2022 and $1,160,000 for 2023), and limits to the total amount of the qualifying property that can be placed in service before a reduction in Section 179 occurs ($2,700,000 in 2022 and $2,890,000 in 2023). The deduction begins to phase out on a dollar-for-dollar basis after $2,890,000 (in 2023) is spent by a given business (thus, the entire deduction goes away once $4,050,000 in purchases is reached), so this makes it a true small and medium-sized business deduction.

With these changes in R&D, Software Development and Bonus Depreciation, if you have not already done so, reevaluate your company’s tax strategy.

1. Plan your fixed asset additions for maximum benefit from both Bonus and Section 179.  That may mean staggering the placed in service dates to avoid the Section 179 limitations.
2. Acquisition versus Development – Companies may now want to consider acquiring property related to research in lieu of developing it. Acquired assets may be eligible for accelerated or bonus depreciation.  Software is a great example of this.
3. Books and Records – If not already in place, implement accounting processes to better identify R&D expenditures (as defined under IRC Section 174) and separate them from other deductible production and administration expenses.
4. Plan for additional federal and state tax expense due to the reduction in expenses on R&D.
5. Keep Projects Going – Reconsider abandoning R&D projects prior to completion. Previously companies were able to write off the remaining basis of R&D costs when they shut a project down. Now, however, they will be required to continue to amortize an abandoned project over its remaining useful life.
6. Research Credits – Under the regular R&D tax credit, R&D expenses that are eligible to be amortized after 2021 are reduced by any excess of the research credit allowed for the tax year. Consider electing the reduced R&D credit elect on a timely filed tax return to eliminate this potential additional add back to income. Taxpayers with taxable income should consider the documentation strategy for eligibility to claim the Section 41 credit, which is now more valuable than an amortizable expense under Section 174. The Section 41 credit is available for qualified research expenses defined, in part, as “research with respect to which expenditures may be treated as specified research or experimental expenditures under Section 174.” Therefore, a taxpayer that previously deducted R&D expenses under Section 174 will likely satisfy the first prong of eligibility for the credit under Section 41 for consistent activities.
7. Startups unable to utilize the credit under Section 41 should consider whether an amortizable expense under Section 174 or an immediate deduction under Section 162 is more appropriate.
8. Domestic versus Foreign Research: The length of amortization under amended Section 174 is dependent upon whether the R&D expenses are attributable to foreign research. The prevalence of technology and web-based research may blur the lines between foreign and domestic research.
9. All of the above should be considered in tax planning, along with other limitations and rules, including the interest expense limitations, excess business loss rules, net operating loss limitations and alternative minimum tax.

Teri Kaye, CPA is a Partner and the Head of the Tax Practice at Daszkal Bolton LLP.  In addition, Teri is the Managing Partner of the Daszkal Bolton Fort Lauderdale office and is a Board Member and Treasurer of the South Florida Manufacturing Association. If you have any questions, please feel free to reach out to Teri at [email protected].