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Avoid a Surprise Tax Bill by Preparing for R&D Expensing Changes Under IRC §174

by David Greenamyre
July 13, 2022

For nearly 70 years, companies have been allowed to expense R&D costs as paid or incurred allowing for an immediate tax deduction under Internal Revenue Code (IRC) §174. The immediate tax deduction allowed under IRC §174 (along with the R&D tax credit) have stimulated private-sector R&D spending for decades. Several industries, particularly those in the technology sector, reinvest earnings and their outside funding directly into R&D spend — causing many to be “loss” companies for both GAAP and tax purposes.

Beginning in 2022, immediate R&D expensing is no longer an option. In December of 2017, the Tax Cuts and Jobs Act (TCJA) amended IRC §174 to require R&D expenditures to be capitalized and amortized over a period of 5-15 years for amounts paid in tax years beginning after December 31, 2021. Additionally, internal software development costs are specifically included as R&D expenditures under the amended IRC §174 and are therefore required to be capitalized and amortized.

What Does This Change Mean for Companies?

Now that immediate R&D expensing is no longer an option in 2022, many companies may find that they have a substantial amount of taxable income and do not have the tax losses they were expecting. Year one (2022) creates a significant tax impact because only half-year amortization is allowed.

For example, assume SaaS Company, Inc. spends $70M on R&D in 2022 and has an overall GAAP loss of $30M for the year. The company will have to capitalize the entire $70M of R&D spend for tax purposes. Assuming five-year amortization and the required midpoint convention, the company would only be entitled to a $7M amortization tax deduction in 2022. Absent any other tax adjustments, the company would have $33M in taxable income for 2022:

2021
(“old” IRC §174 in effect)
2022
(“new” IRC §174 in effect)
GAAP EBIT -$30M -$30M
R&D Spend - +$70M
5-year tax amortization - R&D - -$7M
Taxable Income* -$30M +$33M

*Assumes no other tax adjustments

Even with an unexpected taxable income position, companies may assume they have tax attribute carryforwards to offset the income (e.g., net operating losses (NOL) and tax credits). These attributes are often limited and not available to offset taxable income.

For example, IRC §382 limits the amount of tax attributes due to ownership changes that may have occurred. Furthermore, post-2017 Federal NOLs are limited to 80% of taxable income. Most states conform to the amended §174 and have similar limits on tax attribute utilization. Additionally, many states have specific attribute limitations in place as revenue raisers for their fiscal budgets. (Connecticut only allows taxable income to be offset by 50% of carryforward NOLs and Illinois has a $100K cap on any NOL utilization.)

What this all means is that company stakeholders, the C-suite, treasury function and the tax function should be aware of current law and plan for the very-likely scenario of unexpected cash taxes. With valuations plummeting, market volatility, and the uncertainty of a recession, most companies are watching cash spend closely and forecasting their runway. To avoid a surprise tax bill on top of all of this, understand the changes 2022 will likely bring.

For questions or assistance, contact our tax experts.

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