Effective January 1, 2022, a significant change to the tax treatment of Research and Experimentation expenses went into effect. This change is a result of a provision within the Tax Cuts and Jobs Act of 2017 (TCJA). Prior to January 1, 2022, taxpayers had the ability to expense research and experimentation costs as incurred. These costs are now required to be capitalized and amortized over five years for domestic research and fifteen years for foreign research.
Research and experimentation projects are common among businesses that operate within a technical science field. Businesses with eligible projects will incur costs that eliminate uncertainty incidental to the design, development, or improvement of products, processes, techniques, formulas, software, or inventions. These costs generally include labor, supplies, and contracted labor. Taxpayers are mostly familiar with these costs since they are identified when calculating the R&D tax credit.
A business can evaluate whether certain projects are eligible for the tax credit by ensuring a project satisfies the four-part test.
- Permitted Purpose: Research is conducted for a purpose relating to a new or improved function, performance, reliability, or quality.
- Process of Experimentation: Research must include qualifying activities that evaluate alternatives, test hypotheses, etc.
- Technological in Nature: Research must rely on principles of technical sciences such as physical sciences, biological sciences, computer sciences, or engineering.
- Elimination of Uncertainty: Research is conducted to eliminate technical uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of a business component design.
It is also important to note that the research and experimentation expenses now required to be capitalized and amortized may also consist of additional costs from what was only historically included when calculating the R&D tax credit. The TCJA change expanded the definition of research and experimentation costs to include other items such as overhead and utilities incidental to the research. Taxpayers should review their process for identifying and tracking all costs incurred with research activities to determine the proper amount that should now be capitalized.
The above changes will have a significant impact on many companies, including architecture and engineering firms. Business owners should evaluate the impact of the reduction of the current year expenses to ensure tax estimates and cash flow are being managed appropriately.
Although there is bipartisan support in Congress to provide taxpayer relief, either through repeal or a delay to a subsequent year for when these changes will take effect, nothing has been passed yet. There continues to be hope that some fix may be included in a year-end extenders package. However, as we move further into 2022, taxpayers should be mindful of the new law and plan accordingly.
Information contained in this alert should not be construed as the rendering of specific accounting, tax, or other advice. Material may become outdated and anyone using this should research and update to ensure accuracy. In no event will the publisher be liable for any damages, direct, indirect, or consequential, claimed to result from use of the material contained in this alert. Readers are encouraged to consult with their advisors before making any decisions.