By Jonathan Tucker | Principal, Research & Development Tax Credits
With the enactment of the Tax Cuts and Jobs Act (TCJA) of 2017, significant changes were made to the Internal Revenue Code (IRC), notably to IRC 174. Starting in the tax year 2022, businesses can no longer fully expense their research and experimental (R&E) costs in the year the expenses are incurred. Instead, these expenses must be capitalized and amortized over a five-year period (15 years if the research is conducted outside the United States). In addition, all software development costs are specifically required to be treated as Section 174 R&E expenses.
KBKG Insight:
These changes have a substantial impact on how all businesses account for R&E expenditures. While an unpopular provision of the tax code, it is a requirement to capitalize any expenditures that meet the definition of IRC 174, including software development. The IRS is committed to enforcing this provision, so CPAs should carefully consider these expenditures when filing tax returns.
As CPAs gear up for another tax season, it’s crucial to identify IRC 174 R&E expenditures in order to remain in compliance, and CPAs should start with a business’s financial statements. These expenditures could be expensed or capitalized on financial statements, so it’s important to scope both the income statement and balance sheet. Here’s how to spot them.
Identifying IRC 174 Eligible Expenses
- R&D Expenses:
- Salaries and Wages: Look for accounts such as R&D Salaries, Engineering Salaries, or Product Development Salaries. These accounts may capture direct labor costs for employees engaged in R&D activities.
- Materials and Supplies: Check accounts labeled R&D Supplies, Lab Materials, Testing Supplies, Trail Material, or Prototype Supplies. These may reflect the costs of materials and supplies used in R&D projects.
- Contract Research Expenses: Review accounts named External R&D Services, Engineering Consulting, or Design Fees. These could include payments made to third parties for R&D services.
- Overhead Costs: Examine accounts like Rent, Allocated Overhead for R&D, Utility, or Facility Costs for R&D. These are allocable overhead expenses that may be related to R&D activities.
- Web Development:
- Look for accounts such as Website Development Costs, Web Design Expenses, or App Development Costs. Expenses related to designing, coding, and testing new websites or web applications may be required to be capitalized.
- Software Development:
- Check accounts like Software Development Costs, IT Development Salaries, QA Testing or Software Testing Expenses. These may capture costs associated with creating or improving software products, including salaries of software engineers, cost of testing, and associated overhead, which may be required to be capitalized.
- New Equipment Purchases:
- While the purchase of new equipment is not an IRC 174 expenditure, look at accounts such as R&D Equipment, Lab Equipment, or Prototyping Equipment, because if equipment is used for R&D purposes, the associated costs of developing and implementing new equipment and associated depreciation may be required to be capitalized.
- Process Improvement:
- Examine accounts named Process Improvement, Continuous Improvement, Innovation Expenses, or Development Costs. These accounts may capture costs incurred in the development or improvement of processes, techniques, formulas, inventions, or software that result in a new or improved product.
Action Items
Navigating IRC 174 complexities requires expertise, and KBKG specializes in identifying and categorizing IRC 174 expenditures, ensuring compliance with the tax law changes while optimizing benefits through IRC 41 R&D tax credits. Here’s how KBKG assists:
- Accurate Expense Identification: Meticulously reviewing your financial statements to pinpoint qualifying IRC 174 expenditures.
- Optimized R&D Credits: Maximizing potential to offset tax liabilities with IRC 41 R&D tax credits, by correctly categorizing expenses.
- Ensured Compliance: An annual IRC 174 analysis ensures businesses adhere to current tax rules, preventing penalties and optimizing long-term tax savings.
Harness KBKG’s expertise to capitalize IRC 41 R&D tax credits while navigating the evolving tax landscape with confidence. With industry-leading experts, KBKG’s tailored solutions identify IRC 174 costs and optimize R&D tax credits. Contact a KBKG representative today or visit KBKG.com to learn more on how to thrive in this new era of tax compliance and innovation.
About the Author
Jonathan Tucker | Principal – Research & Development Tax Credits
Jonathan Tucker is based in Atlanta, GA, and has over 20 years of experience providing federal business tax advisory services, primarily in R&D tax credits, to clients in various industries including technology, manufacturing, transportation, healthcare, retail and consumer products, hospitality, media and entertainment, financial, and other professional services industries. Read More