Prior to the Tax Cuts and Jobs Act (TCJA), taxpayers could deduct research and experimental expenditures as paid or incurred, thus receiving a current deduction. An election could also be made to amortize the expenditures over a period of not less than 60 months. A third alternative allowed the expenditures to be amortized over a 10-year period under section 59(e). The TCJA changed the rules for current deductions and amortization with a delayed effective date.
For tax years beginning after Dec. 31, 2021, taxpayers may no longer take current deductions for research and experimental expenditures. For tax years beginning in 2022, they must deduct the expenditures ratably over a five-year period beginning with the midpoint of the taxable year in which the expenditures are paid or incurred. Expenditures attributable to foreign research must be deducted ratably over a 15-year period. The rules in effect for taxable years after Dec. 31, 2021, also apply to software development. According to the Ways and Means Committee, these provisions were enacted because the expenditures have a useful life beyond the year in which they are incurred.
The changes to the treatment of expenditures is an accounting method change. The Treasury Department has not yet provided guidance on how the change will be made, although it has stated that it expects to issue guidance on an automatic change procedure.
Taxpayers in certain trades or businesses, such as software developers and technology companies, may be impacted more than others by these changes. Startups that depend on research for product development will also be impacted. Cash flow will need to take into account the reduced deductions related to amortizing the expenditures.
Qualified small businesses may elect to claim a certain amount of their research credit against their payroll tax liability. The election allows up to $250,000 of the credit to be applied against the employer’s portion of the Social Security taxes (but not the Medicare taxes) instead of against the income tax liability. For tax years beginning after Dec. 31, 2022, the Inflation Reduction Act increased the amount to $500,000 from $250,000 and also allows the election to offset the employer’s portion of both the Social Security and Medicare taxes.
In general, a qualified small business, with respect to a tax year, is one that has less than $5 million in gross receipts and had no gross receipts for any tax year before the five-tax-year period ending with the current tax year.
The provision is intended to benefit startup companies that may not have a tax liability sufficient to claim the credit as an offset to income tax. The election is important in industries such as life sciences and technology where substantial expenditures are made for research but there is often little taxable income to offset the credit. The cash savings from the payroll credit can provide a needed boost for additional investments in research.
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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.