The Capitalization Amortization Issue

THE CAPITALIZATION AMORTIZATION ISSUE

THE CAPITALIZATION AMORTIZATION ISSUE

MEET THE AUTHORS:

Mike Woeber, CPA

Dawson L. Fercho, EA

The Senate is now recognizing the importance of keeping our semiconductor chip development and production here in the U.S. This is paramount to national security. The amount of research & development that will go into this effort is critical to the project’s success. It certainly makes sense that our Congress also recognizes the importance of allowing U.S. companies to expense R&D costs in the year they incurred. This change is particularly significant per R&D tax credit experts Corporate Tax Advisors (CTA).

“This means all taxpayers, not just those in the semiconductor industry, will be able to fully deduct any R&D costs incurred in 2022, rather than writing those costs off over five years. This would be a real win for innovative U.S. companies,” said Mike Woeber, CPA, CEO & President.

Before 1/1/2022, a company that incurred research and experimentation (R&d) expenses could deduct them in the current tax year OR elect to amortize them over 60 months. The default treatment was to deduct R&d costs immediately.

Changes in the Law

The law changed for costs incurred beginning 1/1/2022, though. These R&D costs cannot be deducted currently anymore. Instead, it is mandatory to capitalize them and amortize them over 60 months. Many taxpayers think this means taking the R&d costs reported on Form 6765 and amortizing them. That is not the case, however. We need to define an R&D cost under Section 174 and an R&d cost eligible for the R&d credit under Section 41.

Important Considerations

First, Section 174 defines an R&D cost as ALL COSTS INCIDENT to developing or improving a product, including costs that don’t typically qualify for the R&D credit, such as overhead. These could be utility, benefits, indirect labor, or facility costs, to

THE CAPITALIZATION AMORTIZATION ISSUE

name a few. Again, these costs would not be included in an R&D credit computation but would be subject to amortization under the new Section 174 rules.

Another important consideration is the concept of financial risk. A taxpayer is required to have financial risk in a cost if it is to be considered eligible for the R&d credit. However, there is no financial risk requirement for a cost to be considered a Section 174 R&D cost. The rules here are still very unclear.

The important thing to remember here is that the costs required to be included in the Section 174 amortization are potentially much broader than those allowed in the R&d credit.

Amortization Rule Played Out

Here’s how the amortization rules play out over the five years. For example, let’s assume the taxpayer has $100,000 per year in Section 174 R&D costs. If that’s the case, there will be an $80,000 increase in taxable income in 2022 ($100,000 capitalized and only $20,000 deductible).

Assume the taxpayer incurs another $100,000 of R&D costs the following year. Their taxable income for year two increases by $60,000 (same computation as above but also getting the second $20,000 of amortization from year 1).

So, in theory, if a taxpayer incurs five years of Section 174 costs at a rate of $100,000 per year, they will be getting a $100,000 deduction each year beginning in year six. While this isn’t a realistic scenario, it does show how the 174 amortization is only a timing difference that has its most significant effect on taxpayers in the early years of implementation.

Sections 174 & 41

So far, we have defined R&D expenses subject to the new amortization rules and demonstrated the difference is temporary and the negative tax consequences will be less and less of an impact in later years. Now, let’s clarify how Sections 174 and 41 work independently.

MYTH: If we don’t claim the R&D credit per section 41, we don’t have any Section 174 expenses to add back and amortize over time.

FACTS: The definition of costs under Section 174 is different than what qualifies for the credit. You can have an R&D cost without being eligible for the R&d credit. Remember, the R&d costs under Section 174 are much broader in scope. Section 174 does not reference the R&D credit eligibility. It asks a taxpayer to evaluate the “nature” of the costs related to something new or improved. Most businesses will have these kinds of costs whether they claim the R&D credit or not.

Remember, taking the R&D credit is NOT required to have a Section 174 cost to amortize. So, deciding not to claim the R&D credit doesn’t mean you escape the section 174 rules.

THE CAPITALIZATION AMORTIZATION ISSUE

Staying ahead takes the right advisors

Corporate Tax Advisors (CTA) – Established in 2014 in Huntsville, Alabama, CTA provides tax solutions to Certified Public Accountants and small to large businesses nationwide. With a heavy focus on Research and Development (R&D) Tax Credits, the founding partners work closely with the A|E|C, pharmaceutical, and manufacturing. CTA’s partners, Mike Woeber and Dawson Fercho, have more than 20 years of experience in the R&D Tax Credit industry.

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