Impact of Section 174 capitalization of R&D expenditures on UBI for NFPs

While research and development activities and expenditures may seem common concepts for corporations who are for-profit entities, it’s not an exclusive game. Many not-for-profit organizations (NFPs) are also investing time and money to develop new, or improve upon existing products, processes, software, formulas, inventions or other business components. Internal Revenue Code (IRC) Section 174 historically allowed businesses to either deduct or amortize certain research and development (R&D) costs as an incentive to encourage a business’s effort to increase innovation and development.

Some background

Prior to the enactment of the Tax Cuts and Jobs Act (TCJA) in 2017, taxpayers could deduct certain R&D expenditures as they were incurred or as an alternative, a taxpayer could elect to amortize R&D expenditures over a period of not less than 60 months (5 years). A third alternative allowed a taxpayer to elect to capitalize and amortize R&D expenditures over a 10-year period.

These rules were changed by the TCJA. Effective for tax years beginning after December 31, 2021, taxpayers may no longer take current deductions for R&D expenditures under Section 174. Under the new rules, a taxpayer must generally capitalize domestic R&D expenditures and deduct them ratably over a 5-year amortization period, beginning at the midpoint of the taxable year in which those costs were incurred.

To add context, let’s say an organization were to incur $100,000 of R&D expenditures in 2022. The organization would be entitled to a deduction of $10,000 in 2022 after applying the five-year amortization period and half-year convention in year 1. Assuming the organization makes no other R&D expenditures in 2023 and beyond, they would then be allowed to take a deduction of $20,000 in 2023 through 2026, with the remaining balance of $10,000 falling in 2027.

Additionally, R&D expenditures for foreign research costs are now amortized and deducted over a 15-year period. For purposes of determining foreign research expenditures, those costs are identified based on the location where the research activities were performed, and not the location of the party who actually incurred or paid the expenses.

As the amortization period for these R&D expenditures generally increased following the changes from the TCJA, for-profit taxpayers are expecting their taxable income to increase.

But what are the tax implications to tax-exempt organizations, if any?

Impact on not-for-profit organizations