2023 Changes to the R&D Tax Credit

Published: May 2, 2023
By: Mimi Nguyen
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Since its enactment in 1981, the research and development (“R&D”) tax credit has provided significant monetary benefits to eligible companies. While the research credit is now permanent, there have been several developments in the law related to the credit and the associated expense treatment of research and experimental (“R&E”) costs under IRC Sec. 174. An EisnerAmper Webinar titled: “The New R&D Tax Credit Rules” covered the specific changes that have been implemented regarding the payroll offset limitations and the treatment of 174 expenses.

Webinar panelists included:

Tim Rankins, Tax Director, EisnerAmper
Alexandra Colman, Partner, Corporate Tax Group, EisnerAmper

Payroll Offset Limitation Increase

Prior to 2015, the R&D tax credit was only utilized against income taxes. In 2015, through the Protecting Americans from Tax Hikes (“PATH”) Act, qualified small businesses could use the R&D credits of up to $250,000 against their payroll tax liability. This was considered a huge win for small businesses engaging in R&D activities and, thus, encouraged innovation even if the businesses were not yet profitable. In August of 2022, President Biden signed into law the Inflation Reduction Act, which increased the benefit limit to $500,000 to aid qualified small businesses and encourage them to continue innovating. The eligibility remains the same.

Eligibility

A qualified small business is a corporation, partnership or S corporation that has:

Less than $5 million in gross receipts in the current tax filing; and/or
No gross receipts prior to a five-tax year window that includes the tax filing year.

Section 174 Capitalization Requirements

The Tax Cuts and Jobs Act (“TCJA”) of 2017 has changed how companies treat Section 174 expenses. Beginning tax years on or after January 1, 2022, taxpayers can no longer deduct R&E expenditures under Section 174. Companies are now required to capitalize costs identified as R&E expenditures, and such costs must be amortized ratably over a five-year period for domestic research or over a 15-year period for foreign research.

Additionally, the TCJA also expanded the definition of an R&E expense. According to Section 174^[1], an R&E expense is specified as: “research or experimental expenditures that are paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business.” In addition to the original definition, the following has been added: “Any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.”

All taxpayers currently claiming or planning to claim the R&D tax credit going forward will be affected by this change, especially taxpayers who are not currently assigning R&E expenditures to a capital account. This change requires an additional step in tax preparation each year to calculate Section 174 R&E expenditures each year.

Overall, it is good news to see a payroll offset limitation increase. The main concern is the changes regarding Section 174. Although the changes seem daunting at first, it is expected that additional guidance regarding Section 174 will be released soon. Some legislation has recently come forward to eliminate this requirement going forward. Many tax professionals are hopeful that the Section 174 changes are not here to stay beyond 2023.

[1] 26 USC 174: Amortization of research and experimental expenditures (house.gov).

Business Tax Quarterly: Q2 2023