The 2017 Tax Cuts and Jobs Act included tax law changes that took effect over multiple years. One such change, which became effective for tax year 2022, is the requirement that “Research and Experimental (R&E) Expenditures” be capitalized rather than expensed. This change is especially relevant for start-up technology companies that have significant R&E costs. In the past, such companies could fully deduct their R&E costs in the current year, which greatly reduced their taxable income. Going forward, however, these costs – which include software development costs – will need to be capitalized and amortized. R&E costs for research performed inside the United States will be amortizable over 5 years while research performed outside the United States will be amortizable over 15 years.
For the initial year of amortization, only 50% of the annual deduction is allowed. For example, if a company has $500,000 of 2022 R&E costs from U.S.-based research, then the annual deduction will be ($500,000 / 5 years) = $100,000 per year. For Year 1, however, the deduction will only be $50,000 (which is 50% of $100,000). For Years 2-5, the deduction will be the full $100,000 per year. For Year 6, the deduction will be the remaining $50,000. Effectively, this means that the initial year of the rule change (2022) will bear the brunt of the tax impact since there is no amortization of R&E costs coming from any prior years. Consequently, businesses with relatively high R&E costs should anticipate the following for tax year 2022:
- Showing higher net income than previous years for tax accounting purposes.
- Potentially owing federal income tax even though the business shows a loss for book accounting purposes.
- Planning cash-flow needs to cover any potential tax liability.
There is still hope that Congress will provide retroactive tax relief from this provision (possibly postponing it until 2025). To-date, however, no such relief has been passed.
Please let us know if you have any questions regarding these issues.
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