Innovative Companies are Hitting the Panic Button as 174 Amortization Takes Effect

Update

Despite strong bi-partisan support for the delay or eradication of the amortization of 174 expenditures, Congress failed to act prior to the end of the year, and the changes took effect as scheduled. As it stands now, taxpayers will no longer be able to immediately deduct R&E expenditures and will be required to amortize and capitalize them over a five-year period. 

What is 174 Amortization?

Before we dive into the amortization of 174 expenses I think it is important to first define what a 174 expenditure is. Section 174 of the Internal Revenue Code (“IRC”) is a classification for research and experimentation expenditures. Any expenditures claimed as an R&D expenditure under Section 41 must automatically be categorized as a 174 expense. However, not all 174 expenses are Section 41 R&D expenditures, which means that the amortization law has a much broader impact than just the R&D credit. Back in 2017, The Tax Cuts and Jobs Act (“TCJA”) made substantial changes to the Internal Revenue Code, many of which were favorable to taxpayers.

In order to comply with certain budgetary constraints, the TCJA contained a “sunset,” or an expiration date, for many of its provisions which is what the R&D industry is contending with now. Prior to the passage of the TCJA in 2017, companies could have claimed section 174 expenses as ordinary and necessary expenses under Section 162 as a same-year deduction to reduce taxable income. However, the TCJA contained a provision stating that beginning in the tax year 2022, companies can no longer claim the full deduction in year one; it is now required to be amortized over a five-year period for domestic expenses. It is important to note the interplay between the two independent concepts. 

How does this affect tax liability?

Under the new rules starting with Tax Year 2022, taxpayers are required to amortize their Section 174 R&D Expenses over five years using a half-year convention. Meaning, instead of an immediate 100% deduction in the year in which an expense occurred, taxpayers will only be allowed to expense ten percent (10%) in year 1, and then twenty percent (20%) in each subsequent year until exhausted (year 6 deducts the final 10%) for its 174 R&D Expenses. This is necessary to lay out for clients because the language of the law suggests that all benefits would be realized within the five-year period, however, given the schedule of the deduction the full benefit is not actualized until year six. This change results in a significant reduction in deductible expenses, which in turn creates a significantly higher taxable income.

Although the credit’s immediate value is significantly impacted by this new requirement, R&D tax credits can help to offset this increase in tax burden. If you do not take the R&D credit, your company is still required to amortize 174 expenses which means you will have a substantial increase in tax liability whether you plan to take the R&D credit or not. When you look at the implications of taking the credit from a multi-year standpoint while being amortized, the taxpayer would start evening out and be cash positive inside of the six-year window. This means that although the change in the law has negatively impacted the application of tax savings, it is still more favorable to take the credit than to not and it can be leveraged as a tax mitigation strategy. 

How to Prepare

Using history as our guide and considering the potential widespread negative taxpayer implications, it is still possible that Congress will act this year to overturn the 174 amortization requirement. The initial intent behind the legislation was to incentivize companies to invest in innovation, so it stands to reason that the amortization requirement is unnecessarily punitive and counterintuitive. However, given that the law is currently in effect all prudent business taxpayers and their outside accountants should at least begin assessing the situation in the small chance no fix comes by mid-April if they haven’t already. The R&D credit can ultimately help to offset the spike in tax liability that will result without congressional action.