Research credit changes bring good news and bad news

Changes to research and experimental expenditures

Prior to the Tax Cuts and Jobs Act (TCJA), taxpayers could deduct research and experimental expenditures as paid or incurred, thus receiving a current deduction. An election could also be made to amortize the expenditures over a period of not less than 60 months. A third alternative allowed the expenditures to be amortized over a 10-year period under section 59(e). The TCJA changed the rules for current deductions and amortization with a delayed effective date.

For tax years beginning after Dec. 31, 2021, taxpayers may no longer take current deductions for research and experimental expenditures. For tax years beginning in 2022, they must deduct the expenditures ratably over a five-year period beginning with the midpoint of the taxable year in which the expenditures are paid or incurred. Expenditures attributable to foreign research must be deducted ratably over a 15-year period. The rules in effect for taxable years after Dec. 31, 2021, also apply to software development. According to the Ways and Means Committee, these provisions were enacted because the expenditures have a useful life beyond the year in which they are incurred.

The changes to the treatment of expenditures is an accounting method change. The Treasury Department has not yet provided guidance on how the change will be made, although it has stated that it expects to issue guidance on an automatic change procedure.

Taxpayers in certain trades or businesses, such as software developers and technology companies, may be impacted more than others by these changes. Startups that depend on research for product development will also be impacted. Cash flow will need to take into account the reduced deductions related to amortizing the expenditures.

Increased payroll tax credit

Qualified small businesses may elect to claim a certain amount of their research credit against their payroll tax liability. The election allows up to $250,000 of the credit to be applied against the employer’s portion of the Social Security taxes (but not the Medicare taxes) instead of against the income tax liability. For tax years beginning after Dec. 31, 2022, the Inflation Reduction Act increased the amount to $500,000 from $250,000 and also allows the election to offset the employer’s portion of both the Social Security and Medicare taxes.

In general, a qualified small business, with respect to a tax year, is one that has less than $5 million in gross receipts and had no gross receipts for any tax year before the five-tax-year period ending with the current tax year.