For nearly 70 years, businesses have enjoyed the option of fully deducting their research and experimental (R&E) expenses. But this is scheduled to change in a few short months. Under the 2017 Tax Cuts and Jobs Act, R&E expenses paid or incurred after 2021 must be capitalized and amortized over five years (15 years if research is performed overseas).
Although tax pros have been anticipating this change for almost four years, some feel it will never happen. This year, Congress introduced legislation that would either delay or repeal the unpopular TCJA provision. The most recent attempt was the $3.5 trillion reconciliation bill known as the Build Back Better Act, which would delay mandatory R&E amortization until 2026.
This leaves tax pros wondering if Congress will take action by the end of the year. If I still had my trusty Magic 8-Ball, its answer would most likely be “cannot predict now.” Despite this uncertainty, there are steps tax pros can take now to prepare clients for the future of R&E expenses.
Educate and empower clients
As we approach year-end tax planning season, clients need to be educated about the potential effects of mandatory R&E amortization. For many businesses, this will result in higher taxable income, which means higher estimated tax payments throughout the year. Businesses with cash flow issues, especially resulting from the COVID-19 pandemic, will need advice on how to pay for increased tax liabilities. If Congress ends up delaying R&E amortization, any accumulated cash can be used for other purposes.
A vital component of the education process is presenting clients with tax-planning options. These can range from “must-do's” to “nice-to-do's.” The key is to fully explain each option, provide a preferred course of action, and empower clients to make decisions.
Expense tracking is a must-do
Currently, some businesses don’t distinguish Section 174 R&E costs from Section 162 business expenses. That’s because full deductibility can result under either section. Going forward, businesses will need to adopt bookkeeping procedures that separate R&E expenses, including software development costs, from other business expenses. If they fail to do so, there’s a risk R&E expenses will be improperly characterized as deductible Section 162 expenses.
Also, if businesses don’t do so already, they will need to track their expenses by location. Under the TCJA, R&E amortization periods (five versus 15 years) depend on whether research is performed in the U.S. or abroad.
Improving expense tracking is a beneficial exercise, even if Congress delays R&E amortization. It never hurts to ensure clients have the most accurate and detailed records as possible.
Nice-to-do planning moves
Assuming Congress doesn’t delay R&E amortization, businesses should act now to maximize the benefit of currently deducting R&E expenses. This would involve accelerating research activities into 2021, if possible. If amortization is delayed, businesses have more time to plan out their research activities. Just make sure all high-dollar research projects are performed before the effective date of the provision.
Businesses also have the opportunity to evaluate whether foreign research, including software development, can be relocated to the U.S. This is a smart move from a U.S. tax perspective because expenses would be amortized over five years rather than 15 years. Of course, businesses would need to see if relocation would work logistically and examine any effects from a foreign tax perspective.
Last, but not least, businesses can assess whether they really need to develop their own software. From a tax perspective, purchasing software could be more beneficial because the costs are depreciated over three years and are eligible for bonus depreciation. This is much better than amortizing software development costs over five years. Alternatively, businesses could look into leasing software, which would be deductible as a business expense.
What about the research credit?
Businesses that haven’t taken the research credit in the past, but would be harmed by mandatory R&E amortization, may want to explore that option. Tax credits are generally more beneficial than amortization deductions because they reduce tax liability dollar-for-dollar. However, it’s harder for an R&E expense to qualify for the research credit. Also, the credit is for increasing research activities, meaning that qualified expenses must exceed a certain baseline. For businesses with stagnant R&E budgets, the research credit will provide little or no benefit.
Hope for the best, prepare for the worst
When it comes to the future of R&E expenses, tax pros should hope for the best, but prepare for the worst. Proactive tax planning shouldn’t be put on hold just because Congress may delay R&E amortization at some point. By acting now, tax pros could save businesses money down the line.
