Relatively recent changes to the tax treatment of research and experimental (R&E) expenditures can impact many manufacturers’ tax bills. The most significant changes took effect in 2022 thanks to amendments made by the Tax Cuts and Jobs Act (TCJA).
The TCJA requires businesses to capitalize R&E expenditures under Internal Revenue Code (IRC) Section 174 and amortize them over five years (15 years for research conducted outside the United States). Previously, businesses had the option to immediately deduct these expenditures. Given the potential impact of these lost current deductions, it may be advantageous to study your R&E expenditures and consider these three strategies for reducing your tax bill.
Revisit the R&D credit
One potential tax-saving option is to determine whether your manufacturing company’s R&E expenditures qualify for the research credit under IRC Sec. 41 (commonly referred to as the “research and development,” or “R&D,” credit). Tax credits generally are more valuable than tax deductions. While both save taxes, tax deductions lower your taxable income and tax credits reduce your tax bill dollar for dollar.
The Inflation Reduction Act (IRA), enacted in 2022, expanded the ability of start-up businesses to use research credits to offset payroll tax liability. The TCJA allows start-ups — generally defined as companies that are less than five years old and have less than $5 million in gross receipts — to claim research credits against up to $250,000 in Social Security tax liability. The IRA allows these businesses to claim up to an additional $250,000 against their Medicare tax liability.
Keep in mind that not all R&E expenditures will qualify for the research credit. Sec. 174 applies to a broad range of expenditures, including both direct and indirect R&E expenses. In contrast, Sec. 41 is generally limited to only direct expenses.
Reclassify R&E expenditures
Another option is to conduct a study of your R&E expenditures to determine whether any of them can be reclassified as deductible business expenses under IRC Sec. 162. Before the TCJA, businesses didn’t need to worry too much about whether expenses were deductible under Sec. 174 or Sec. 162, because the tax treatment was essentially the same. Now, however, determining the proper classification of expenses can mean the difference between capitalizing them or deducting them immediately.
As you review these expenses, remember that under the TCJA, to be eligible for the research credit, an expense must be treated as an R&E expenditure under Sec. 174. So, it’s important to weigh the potential benefits of reclassifying R&E expenses as deductible business expenses against the potential loss of research credits.
Consider purchasing software
Another significant change made by the TCJA involves the tax treatment of software development costs. Previously, businesses had the option of deducting these costs as they were paid or incurred.
Now, however, software development costs are treated as R&E expenditures required to be capitalized and amortized under Sec. 174. A potential strategy for easing the tax blow of this change is to purchase software, which is deductible immediately as a business expense, rather than developing it in-house.
Turn to your advisor
The requirement to capitalize and amortize R&E costs can have a significant tax impact on your manufacturing company. We can help you determine if your R&E expenditures qualify for the research credit or if you can (and should) reclassify any of them as deductible business expenses.
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