How to Prepare for the 2022 R&E Capitalization Requirement
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Steps To Prepare for the 2022 R&E Capitalization Requirement
Written by Lynn M. Mucenski-Keck, Principal
A new and significant deduction limitation for research and experimental (R&E) expenses takes effect in 2022. The ability to expense R&E spending, coupled with the research and development (R&D) tax credit, are two important ways the tax code incentivizes businesses to make this critical investment. However, under the December 2017 Tax Cuts and Jobs Act (TCJA), R&E expenses are no longer deductible in 2022; instead, taxpayers are required to capitalize and amortize their Section 174 R&E expenses over a 5-year period (or 15 year-period if attributable to foreign research).
And while many businesses were holding out for Congress to extend the ability to immediately deduct Section 174 R&E expenses for the 2022 taxable year, no such legislation has been passed as of today. With final estimated tax payments for the 2022 taxable year approaching, coupled with the need to issue audited financial statements, businesses will be forced to develop an approach to address R&E capitalization.
What This Means for Your Company
Companies in many industries, including the technology and life sciences industries that incur significant R&D expenses will be affected by this change in tax law. Since the option to immediately expense these costs is currently not available for the 2022 taxable year, companies will be required to amortize their R&E expenditures beginning with the midpoint of the 2022 taxable year. This decrease in allowable deduction could cause the creation of taxable income, even though the business may have no previous history of federal taxable income.
While some companies may think that they have ample net operating losses (NOLs) to offset any potential taxable income, careful examination is required to determine the year the net operating losses were created by the company. While it is true net operating losses incurred in taxable years before December 31, 2017, will fully offset taxable income, the TCJA made significant changes to the ability to utilize net operating losses incurred after December 31, 2017. Under the TCJA amendment net operating losses that were incurred after December 31, 2017, and applied to taxable years after December 31, 2020, can only be utilized to offset up to 80% of taxable income, leaving 20% of taxable income subject to federal income tax.
For a simple example, assume a C corporation has $10,000,000 of income and $15,000,000 of R&E expenses for the 2022 taxable year. Prior to the 2022 taxable year, the business would record a $5,000,000 net operating loss. However, due to the Section 174 R&E capitalization requirement, the business now will be required to amortize the $15,000,000 of R&E expenditures and only be allowed a deduction of $1,500,000 (15,000,000/5 x ½) for the 2022 taxable year. This results in taxable income of $8,500,000 (10,000,000 – 1,500,000). If the only NOLs for the corporation were created after December 31, 2017, the company utilization of the net operating losses will be limited to 80% of taxable income. At least $1,700,000 of taxable income ($8,500,000 x 20%) would remain after the utilization of net operating losses, resulting in federal tax due of $357,000 (1,700,000 x 21%).
For further assistance in assessing the federal cash impact of the Section 174 R&E required capitalization policy for the 2022 taxable year, please review the steps provided in the...
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