Recent changes to Section 174 (S174) of the U.S. Internal Revenue Code have created significant uncertainty for both accountants and startup founders, as the new rules prevent businesses from immediately deducting R&D expenses starting in 2022.
This represents a significant shift from nearly 70 years of guidance under U.S. Generally Accepted Accounting Principles (GAAP), which have historically permitted the immediate deduction of R&D expenses under Accounting Standards Codification 730.
This creates serious challenges for startups, which often operate with minimal runway in their early stages and could now face much higher tax bills than in previous years.
It’s also a complex and somewhat unclear new landscape for accountants, since many expected these changes—introduced by the 2017 Tax Cuts and Jobs Act (TCJA)—to be repealed before December 31, 2021.
While it’s now too late to reverse the new amortization and capitalization rules before the 2022 tax filing deadlines, there’s still hope that a bipartisan bill currently being reintroduced in the Senate could let businesses retroactively benefit from these crucial deductions.
In the meantime, what immediate impact will the new Section 174 rules have on businesses this year?
Reduced audit protections
To start, at the end of 2022, the IRS released Revenue Procedure 2023-8 as updated guidance that tax preparers must follow under the new capitalization rules.
For example, Rev. Proc. 2023-8, Section 3.02(7) specifies that there is no audit protection for research and experimental expenses incurred in tax years before 2022. This means that, going forward (after the 2022 tax year), the IRS could change how taxpayers define certain costs if they now fall under the new definition of R&E expenses paid or incurred under S174.
From now on, S174 costs will cover a broader range of expenses than those included in the definition of Qualified Research Expenditures for the R&D tax credit (Section 41). As a result, accountants will need to be more precise and detailed than ever when preparing IRS filings to protect against the increased risk of audits.
Perhaps the most frustrating part for everyone involved—taxpayers, businesses, and even the IRS—is that it’s still not entirely clear which costs must be capitalized going forward.
Additional Considerations for Tax Preparers
While there’s still a lot of uncertainty about how the IRS will ultimately handle filings now that the TCJA rules are in effect—even as tax deadlines approach—there are a few extra points tax professionals should keep in mind regarding S174.
- Foreign Tax Issues (Section 199A Deduction): The allocation of R&E costs under Treasury Regulation Section 1.861-17 affects how businesses use the foreign tax credit, the foreign-derived intangible income (FDII) deduction, global intangible low-taxed income (GILTI), the base erosion and anti-abuse tax (BEAT), the calculation of effectively connected income, and the Section 199A qualified business income deduction.
- The impact of deferring deductions for R&E costs is especially important for startups with cross-border operations, and may require specialized expertise to ensure businesses are maximizing their available deductions.
- Abandoned projects: Previously, businesses could deduct the remaining expenses for projects that were abandoned or disposed of. Under the TCJA, taxpayers must now continue to amortize R&D expenses over their remaining useful life.
- The challenge here is that this rule seems to conflict with other parts of the tax code related to abandonment costs (such as IRC Section 165), so accountants should stay alert and be prepared for possible audits when claiming these types of expenses.
- R&D tax credits: There are many federal and state R&D tax credits available to businesses that qualify under IRC Section 41, which can help offset some of the new expenses that must be capitalized under S174. However, to qualify for these credits, research expenses must meet the definition of R&E expenditures under IRC Section 174.
- That means accountants need to be thorough in determining what actually qualifies, which could also reveal new opportunities for credit benefits along the way.
R&D Tax Credits Are More Important Than Ever—and a Key to Understanding S174
The silver lining? With many businesses now having to report taxable income at higher rates—or for the first time—the R&D tax credits available under Section 41 are more valuable than ever for reducing tax liabilities.
That’s why the R&D tax credit study you conduct as part of your claim is a great way to identify which costs fall under Section 174.
At Boast, we help innovative businesses identify and quantify all available R&D activities and expenses that can qualify for tax credits to not only minimize the impact on their annual tax bills, but extend their runway in the face of a rocky financing landscape.
Using our AI-driven platform, Boast seamlessly integrates your business’ financial and payroll data alongside the activity and project tracking systems your product teams use every day. This provides a real-time, automated way for you to identify and quantify all available R&D activities and expenses—including Section 174 expenses—that can take a lot of the guesswork out of the claims process (and can be a critical asset to pass onto your CPA).
To learn more about how your team can develop an R&D Capital Strategy that aligns with the new U.S. tax code, join our weekly #InnovatorsLive event on LinkedIn every Friday at 12pm ET/9am PT.
