While research and development activities and expenditures may seem common concepts for corporations who are for-profit entities, it’s not an exclusive game. Many not-for-profit organizations (NFPs) are also investing time and money to develop new, or improve upon existing products, processes, software, formulas, inventions or other business components. Internal Revenue Code (IRC) Section 174 historically allowed businesses to either deduct or amortize certain research and development (R&D) costs as an incentive to encourage a business’s effort to increase innovation and development.
Prior to the enactment of the Tax Cuts and Jobs Act (TCJA) in 2017, taxpayers could deduct certain R&D expenditures as they were incurred or as an alternative, a taxpayer could elect to amortize R&D expenditures over a period of not less than 60 months (5 years). A third alternative allowed a taxpayer to elect to capitalize and amortize R&D expenditures over a 10-year period.
These rules were changed by the TCJA. Effective for tax years beginning after December 31, 2021, taxpayers may no longer take current deductions for R&D expenditures under Section 174. Under the new rules, a taxpayer must generally capitalize domestic R&D expenditures and deduct them ratably over a 5-year amortization period, beginning at the midpoint of the taxable year in which those costs were incurred.
To add context, let’s say an organization were to incur $100,000 of R&D expenditures in 2022. The organization would be entitled to a deduction of $10,000 in 2022 after applying the five-year amortization period and half-year convention in year 1. Assuming the organization makes no other R&D expenditures in 2023 and beyond, they would then be allowed to take a deduction of $20,000 in 2023 through 2026, with the remaining balance of $10,000 falling in 2027.
Additionally, R&D expenditures for foreign research costs are now amortized and deducted over a 15-year period. For purposes of determining foreign research expenditures, those costs are identified based on the location where the research activities were performed, and not the location of the party who actually incurred or paid the expenses.
As the amortization period for these R&D expenditures generally increased following the changes from the TCJA, for-profit taxpayers are expecting their taxable income to increase.
But what are the tax implications to tax-exempt organizations, if any?
For NFPs holding alternative investments that are partnerships, they will receive an annual schedule K-1 which reports their share of any income or loss generated by the partnership for a given tax year. To the extent any of the allocable income or loss is unrelated business income (UBI), the organization is required to report this income on a Form 990-T.
These alternative investment partnerships often have multiple underlying investments. To the extent the underlying investments generate R&D expenses, the partnerships will report these amounts separately on the Schedule K-1 to enable organizations to elect to capitalize these expenditures. Identifying R&D costs on the Schedule K-1 is important as they are typically separately stated as Section 59(e) expenditures and may also be identified as expenses related to the UBI data disclosed within a separate Schedule K-1 footnote.
Historically tax-exempt organizations could claim the pass-through R&D costs identified as related to an unrelated trade or business as deductions against UBI. However, as with their for-profit counterparts, NFPs will now need to treat these pass-through costs differently starting in 2022. NFPs will need to capitalize and amortize over 5 years the total amount of U.S.-sourced R&D costs reported on the Schedule K-1 from the alternative investments they own. R&D costs identified as foreign costs will need to be capitalized and amortized over a 15-year period.
To further complicate matters for an NFP owning alternative investments and adjusting to this change, oftentimes these taxpayers may file state income tax returns to report state-sourced UBI passed through from their partnership investment, in addition to their share of Federal UBI reported on a Form 990-T described above. The rules for conformity with the new R&D rules may vary by state. NFPs will need to be aware of the state rules and adjust accordingly.
Like for-profits that incur these expenditures directly, a tax-exempt organization may see an increase in the amount of unrelated business taxable income generated through their alternative investments for fiscal years beginning after December 31, 2021.
Finally, as part of their annual tax planning, NFPs should monitor any Schedules K-1 they receive that report the Section 59(e) R&D expenses. The organization will then need to maintain appropriate documentation to support the amount of R&D expenses reported on the Schedule K-1, the deduction taken in the current tax year, and the amount to be deducted in subsequent years.
To help with reporting and calculating, on September 9, 2023 the IRS announced in Notice 2023-63 their intention to issue proposed regulations containing technical guidance for capitalizing and amortizing R&D costs under Section 174 as amended under the TCJA. Until proposed regulations are issued by the IRS, Notice 2023-63 will serve as interim technical guidance.
Wondering about the next steps for your organization? Reach out to your Baker Tilly tax advisor or connect with our NFP specialists today.
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.