Many taxpayers are facing mandatory capitalization of specified research or experimental expenditures (SREs) required under Internal Revenue Code (IRC) Section 174.1 Under the Tax Cuts and Jobs Act of 2017 (TCJA), this new capitalization requirement is effective for taxable years beginning after December 31, 2021 and reduces the current deduction available for research and development (R&D) costs in the tax year incurred. However, conforming amendments to §41 and 280C may potentially provide an enhanced permanent tax savings opportunity to mitigate the impact of the new §174 capitalization requirement.
For taxable years beginning on or after January 1, 2022, §174 allowed taxpayers to treat certain research or experimental expenditures (R&E expenditures) as expenses for which a deduction was allowed in the year incurred. The TCJA amended §174 requiring taxpayers to capitalize SREs for taxable years beginning after December 31, 2021. U.S.-based SREs are allowed a five-year amortization recovery period, while non-U.S.-based SREs are afforded a 15-year amortization recovery period, with a midyear convention.
The TCJA also made conforming amendments to §41 and §280C. Section 41 provides a tax credit to incentivize taxpayers to invest in research and development (research credit). For tax years beginning prior to January 1, 2022, §41 required qualified research expenses (QREs) to be attributable to research with respect to which expenditures may be treated as expenses under §174. Thus, taxpayers had the option to expense or capitalize QREs under §174. Under the TCJA, that option is no longer available as QREs must now be capitalized and amortized.
For taxable years beginning prior to January 1, 2022, §280C(c)(1) disallowed a deduction for the portion of the QREs equal to the amount of the research credit claimed. The purpose was to avoid providing both a deduction and a credit for the same amount. To avoid having to modify federal taxable income by this disallowed tax deduction, taxpayers could elect under §280C(c)(3) to reduce the current year research credit amount by the maximum corporate tax rate of 21%.
In a conforming change, the TCJA removed the language under §280C(c) that disallowed a tax deduction for QREs in the amount of the research credit for such taxable year but left the portion of §280C(c) relevant to capitalizing and amortizing R&E expenditures. Effective for tax years beginning on or after January 1, 2022, §280C(c)(1) provides:
If the amount of the credit determined for the taxable year under Section 41(a)(1) exceeds the amount allowable as a deduction for such taxable year for qualified research expenses or basic research expenses, the amount chargeable to capital account for the taxable year for such expenses shall be reduced by the amount of such excess.”
Amended §280C(c) does not explicitly state whether a reduction in the amount chargeable to capital account is required when a taxpayer’s research credit does not exceed the amount allowable as a deduction. Section 280C(c)(2) still provides the option to “tax-effect” the research credit, but there is no requirement for taxpayers to make this election in a given taxable year.
Thus, in a taxable year, when a taxpayer’s research credit amount does not exceed the amount allowable as a deduction for QREs or basic research expenses, it appears that the taxpayer may not need to adjust its federal taxable income under §280C(c). This could mean that the §280C(c) election may rarely apply for tax years beginning on or after January 1, 2022.
For example, assume a C corporation taxpayer claims a research credit of $700,000 under the pre-TCJA regime, with QREs of $10 million. For simplicity, assume that QREs equal SREs. Under pre-TCJA rules, §174 would have afforded the taxpayer a current deduction of $10 million. However, §280C required the taxpayer either to reduce the amount of the current §174 deduction of $10 million by the full amount of the research credit or reduce the research credit by 21% (via making a §280C(c) election). Either way, this results in a net tax liability benefit of $553,000 ($700,000 x (1 − 21%)).
Now consider the same example following the TCJA legislation. Assume all of the taxpayer’s QREs were U.S.-based. Under the new law, §174 requires the taxpayer to capitalize all $10 million of its QREs. With a five-year amortization recovery period under a midyear convention, this should yield a 10% amortization deduction in the current year of $1 million. Thus, the taxpayer’s research credit of $700,000 does not exceed the allowable amortization deduction of $1 million. Therefore, under §280C(c), a position may be available to avoid either adding back the amount of the credit to federal taxable income or making a reduced credit election under §280C(c)(2). Thus, the taxpayer may be able to claim a research credit of $700,000 with no impact to tax income, potentially resulting in $147,000 of additional permanent tax savings as compared to the pre-TCJA law.
This potential opportunity provides a permanent tax rate benefit. For financial statement reporting purposes, the additional benefit will generally reduce a company’s effective tax rate and increase earnings per share, which may be attractive to many taxpayers.
At this time, the IRS has not issued substantive guidance for the changes to §174 and §280C(c) under the TCJA, other than allowing taxpayers to use automatic accounting method change procedures to switch to capitalizing R&D expenses. The TCJA legislative history behind this conforming change to §280C is minimal and does not provide insight on congressional intent. Furthermore, select commentary provided by the IRS prior to the TCJA’s enactment appears to conflict with the position described in the example above.
The IRS documents, publishes, and maintains records of policies, authorities, procedures, and organizational operations through the Internal Revenue Manual (IRM). In an IRM Section last revised on February 24, 2017, prior to the TCJA’s passage and before amendments to §280C became effective, the IRS wrote:
Further, taxpayers not electing to take a reduced credit under IRC 280C(c)(3) must continue to reduce applicable deductions, amounts chargeable to capital account, and credits for the taxable year by the full amount of the research credit as required by IRC 280C(c)(1) and IRC 280C(c)(2).”2
This implies that the IRS may interpret §280C, at least as effective for tax years beginning prior to January 1, 2022, to require the reduction of amounts chargeable to capital account equal to the full amount of the research credit for the current year if a §280C election is not made.
The IRS additionally publishes audit technique guides, also known as Market Segment Specialization Program (MSSP) guides, which provide IRS auditing techniques, assist with issue identification and development, and interpret tax law. Audit technique guides provide useful insight to tax professionals, but the IRS disclaims that no guarantees are made concerning technical accuracy after the publication dates of the guides. An IRS MSSP guide published in March 2002 contains the following example on this issue:
Company A’s total research credit is $2,000 and its IRC section 174 expenses are $500,000. The company elects to capitalize its IRC section 174 expenses. Under IRC section 280C(c)(3) the company can reduce the capitalized expenses to $498,000 or reduce the amount of IRC section 41 credit by the amount of tax saved by not reducing the IRC section 174 expenses.”3
In this example, the IRS again reduces the capitalized expenses by the total amount of the research credit, $2,000, and not necessarily by the “excess” as defined in the former §280C(c)(2) and current §280C(c)(1).
The Joint Committee on Taxation (JCT) is a congressional committee that publishes general explanations of enacted tax law, commonly referred to as Blue Books. While not legislative history, Blue Books may provide insight on legislative intent. The TCJA Blue Book, published by the JCT in 2018, seems to provide a contrary view to the IRS commentary described above:
Thus, if a taxpayer’s research credit under Section 41 for a taxable year beginning after 2021 exceeds the amount allowed as an amortization deduction under the provision for such taxable year, the amount chargeable to capital account under the provision for such taxable year must be reduced by that excess amount.”4
This supports a position that the amount chargeable to capital account should only be reduced by the amount of the “excess” as defined in §280C(c)(1)—not necessarily by the entire research credit—and only in instances when the amount of a taxpayer’s research credit exceeds the amount allowed as a deduction in any given tax year. The JCT Blue Book does not provide further insight for when a taxpayer’s research credit does not exceed the amount allowed as an amortization deduction, which could imply that in cases where the research credit amount does not exceed the amount allowable as a deduction, no adjustments need to be made to federal taxable income or the research tax credit under §280C(c).
Since JCT Blue Books are not primary authority and the IRS has not issued further guidance on the application of amended §280C(c)(1) since publishing the internal agency commentary referenced above prior to the passage of the TCJA, taxpayers face uncertainty as to when they should adjust federal taxable income under §280C and whether the adjustment should be for the full amount of the research credit. It also is unknown what position the IRS will ultimately take on this issue or if the agency will even issue any guidance on this in the future.
As such, taxpayers should consider this uncertainty when making decisions on the applicability of §280C to current research credit claims. If the TCJA changes to §174 are repealed or postponed, it’s likely that conforming amendments to §280C also will be made, some of which could potentially be retroactive in nature.
For further information on how these changes to §174, 41, and 280C may impact your 2022 tax return, please reach out to a tax professional at Forvis Mazars or submit the Contact Us form below.
- 1Unless otherwise stated or clear from the context, all references to “Section,” “Sec.,” or “§” in this memorandum are to the Internal Revenue Code of 1986 (the “Code” or “IRC”), as amended, and references to “Treasury Regulation,” “Treas. Reg.,” or “Reg. §” are to regulations promulgated under the Code.
- 2IRM 8.7.1.4.2
- 3MSSP Poultry Industry (3123-013), TPDS #87537E, p.14
- 4Joint Committee on Taxation General Explanation of Public Law 115-97 (JCS-1-18), December 2018, p.145