Major Changes Coming in 2022 to §174 Deduction of Research Expenses

Major Changes Coming in 2022 to §174 Deduction of Research Expenses

A major change is coming next year to the tax deduction for research and experimental (R&E) expenditures under Code Sec. 174. For tax years beginning after 2021, R&E expenditures paid or incurred during the tax year must be amortized and deducted over a five-year period (15 years if foreign-sourced). This change made by the Tax Cuts and Jobs Act (TJCA) will eliminate the current option for taxpayers to expense such costs and deduct them immediately, including software developmental costs. Businesses will need to start planning for this change, including evaluating any upcoming R&E expenditures.

R&E Expenses Before 2022

Under current law, a taxpayer that pays or incurs R&E expenditures in its trade or business during the tax year may elect to:

• expense them immediately and deduct in the year paid or incurred,
• amortize and deduct them ratably over a period of at least 60 months beginning with the month the taxpayer first realizes benefits from the expenditures, or
• amortize and deduct them ratably over a period of 10 years under Code Sec. 59(e) for alternative minimum tax (AMT) tax purposes beginning with the tax year in which the expenses are paid or incurred.

The expensing and amortization elections are intended to encourage research and experimental activities and eliminate uncertainty regarding the tax treatment of R&E costs. A taxpayer that does not make any election must capitalize R&E expenses and deduct them through depreciation or amortization.

If the research is not successful any unamortized costs may be claimed as a deduction upon the disposition, retirement, or abandonment of property associated with the expenses. This is a disadvantage of amortizing R&E expenditures and lead taxpayers to elect to expense the costs.

Software Developmental Costs

R&E expenditures for this purpose are generally research and development (R&D) costs incurred in the development or improvement of a product in the experimental or laboratory sense. Software developmental costs may be treated similarly to R&E expenditures. 

Under Rev. Proc. 2000-50, software developmental costs either may be:

• expensed immediately and deducted in the year paid or incurred, or
• amortized and deducted ratably over a period of at least 60 months from the date of completion of development or over 36 months from the date the software is placed in service.

The expensing or amortization treatment applies only if the taxpayer consistently treats the software development expenditures accordingly.

Expenses incurred for acquisition of software are either capitalized or amortized over 36 months beginning with the month the software is placed in service. They are also eligible for bonus depreciation. The cost of leasing or renting software for use in the taxpayer’s trade or business is deductible as an ordinary business expense.

R&E Expenses After 2021

For tax years beginning after 2021, R&E expenditures paid or incurred by the taxpayer generally must be amortized and deducted over five years if conducted in the United States (15 years if conducted outside the United States). This change eliminates the option to immediately expense R&E expenditures beginning in 2022.

This includes expensing for software developmental costs because they are specifically included in the definition of R&E expenditures under Code Sec. 174 beginning in 2022. Thus, the options provided in Rev. Proc. 2000-50 for software developmental costs are no longer available after 2021. The change, however, does not affect the options for software acquisition costs.

The new amortization rule for R&E expenditures is a departure from generally accepted accounting principal (GAAP) rules that requires most research and development costs to be expensed immediately.

Under the new rules beginning in 2022, the amortization period for R&E expenditures (including software developmental costs) begins at the midpoint of the tax year when the expenditures are paid or incurred. Amortization must continue even if the underlying property is disposed, retired, or abandoned during the amortization period.

Accounting Method Change

The TJCA provides that a change to a five-year amortization period for R&E expenditures (15 years for foreign sourced) is a change in a method of accounting. The change will be treated as initiated by the taxpayer with the consent of the IRS and implemented on a cutoff basis with no section 481(a) adjustment. The IRS expected to issue guidance on whether this will be an automatic method change filed on Form 3115.

Planning for Change

The option to immediately expense R&E expenditures has been an important tool for businesses for a long time. Thus, the change to require amortization beginning in 2022 will require some business to evaluate their future R&E expenditures more carefully. The following are just a few items should consider for their future R&E expenditures.

• Acquisition vs Development—A taxpayer may want to consider acquiring property related to its research, rather than developing it. Acquired assets with short depreciation recovery periods may be eligible for bonus depreciation (100 percent through 2022).
• Software Costs—Similarly, a taxpayer may consider acquiring software rather than developing it given the shorter amortization period (36 months) compared with the period for developmental costs (60 months).
• Tracking Expenditures—A taxpayer may need to start tracking R&E expenditures, including software developmental costs, by location given the different amortization periods for domestic and foreign expenditures (5 years and 15 years respectively).
• Research Credit—R&E expenditures that are eligible to be amortized after 2021 are reduced by any excess of the research credit allowed for the tax year. A taxpayer that wants to avoid reducing its deduction may instead elect to reduce its research credit. The taxpayer may need to review this election given that the section 174 deduction may be deferred after 2022 instead of expensed.
• Estimated Taxes—A taxpayer may have higher estimated tax payments (federal and state) beginning in 2022 since the deductions for R&E expenditures must be deferred over several tax years, as opposed to expensed and immediately deducted.

The TJCA change requiring amortization of R&E expenditures was made to help pay for the various other tax breaks (for example, lower corporate income tax rates). Currently, there are several bipartisan legislative proposals in Congress to either repeal or delay the change for R&E expenditures

By John Buchanan, J.D., LL.M.

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