What Is the New Capitalization Rule?
New federal tax rules require businesses to capitalize and amortize certain research and development (R&D) costs. Historically, the rules permitted the immediate write-off of R&D expenses. Now, companies which are generating revenue could be required to pay tax because they are no longer able to use R&D costs incurred during the year to generate losses. This is because a large portion of the tax deduction associated with the costs is delayed under the new rule.
Suppose in 2021 Company A generates $500,000 of revenue and incurs $1,000,000 of deductible R&D expenses (i.e., salaries, certain indirect expenses, research supplies, etc.). Company A would have reported a $500,000 taxable loss. Likewise, assume in 2022 Company A collects another $500,000 of revenue and spends another $1,000,000 on R&D expenses.
Under the new capitalization rule, Company A will only be able to deduct $100,000 of the 2022 R&D expenses. As a result, Company A will recognize $400,000 of taxable income. Unless Company A has prior period net operating losses to offset the income, Company A will be required to pay tax at 21%. (If Company A has unused research credits, it may be able to offset all or part of the tax as a way of mitigating the issue.)
In the second example above, the remaining 2022 capitalized R&D expenses ($900,000) are deductible over the next four years. This assumes that the expenses were incurred in the U.S. R&D costs incurred in the U.S. are subject to a five year amortization schedule (which effectively requires six years for the full write off, since only 1/10th of the amortization is allowed in the first year). International R&D costs are required to be amortized over a 15 year-amortization schedule. For companies that rely on international research, this is a harsh change.
Note: For companies that incur R&D costs every year, eventually, the total amount of amortization allowed would produce a large deduction because of the cumulative effect of amortization from each year, but in the intervening years, this change could cause unexpected cash flow issues associated with federal and state income tax payments.
When Is It Effective?
The new rule is effective on January 1, 2022 for calendar year taxpayers. This law change was originally included in the 2017 Tax Act, but the effective date was delayed until 2022.
Can Corporate Taxpayers Use Net Operating Losses or Unused Research Credits From a Prior Tax Period To Offset Taxable Income/Tax Generated by the Law Change?
Generally, yes. However, tax rules may limit the amount of prior year losses available as a carryforward deduction, depending on when the loss was generated and/or if the corporation’s ownership changed since the loss was generated. Determining whether prior year losses are limited by these rules may require a complex analysis. If management expects to rely on prior year losses to offset 2022 income, availability of prior period losses should be evaluated well in advance of the tax reporting/payment deadlines.
Unused prior year credits are also subject to limitation rules if the “change in ownership” rules apply. Again, this can be a complex analysis. Be sure to allow adequate time for a full evaluation.
Could This New Rule Be Cancelled or Delayed Retroactively?
A delay or permanent termination of this rule would require Congress to pass a new law. Certainly, that is a possibility. There appears to be considerable support in Congress for at least a further delay of the effective date of the new capitalization rule. However, at this time, no bills containing the required change appear likely to become law.
Does This Change Affect the Company’s Federal Research Credit Claim?
No. The research credit rules are not affected by the new capitalization rule. This means that although the qualifying R&D costs are not immediately deductible, those same costs should still be considered in the credit calculation.
Keep in mind that companies who were able to claim employee retention credits and other payroll incentives in recent years will need to consider how that affects their ability to claim research credits.
Who Should I Contact With Questions?
If you have questions or would like more information about how this law change could affect your tax 2022 tax reporting, or what R&D costs are required to be capitalized under the new rule, please send us an email.
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