Section 174 Amortization: Better planning means better outcomes

By John W. Allen, CPA

You're not alone if you’re confused and distressed about amortizing research expenses under IRS Section 174. Businesses that depend on research to generate innovative products and services now face uncomfortable questions about complying while minimizing the blows to their cash flow.

While aspects of Section 174 amortization remain uncertain, it is reasonable to consider the following:

• Identifying Section 174 expenses versus R&D qualified expenses.
• Understanding Section 174 amortization and its impact.
• Tips for managing the initial tax-liability increase and preparing for the tax year 2022 and future years.

Below are the highlights of a recent webinar on the subject, and additional discussions on various tax topics are planned. Don't hesitate to contact us at info@cpabr.com if you want to hear about future webinars and be part of our email updates.

Section 174 vs. Section 41

Section 174 broadly covers all expenses related to research and experimental activities.  Section 41 covers qualified research expenses for the purposes of the R&D credit.

The two overlap, but there are significant differences.

The IRS broadly defines Section 174 expenses as "research or experimental expenditures which are paid or incurred by the taxpayer during such taxable year in connection with the taxpayer's trade or business." Typically, these research-related expenses include costs of supplies, employees, contractors, and rental or lease of computers and cloud hosting.

However, those Section 174 expenses constitute an entire galaxy, while the research expenses that qualify for R&D tax credits are distinct planets and stars.

Not every 174 expense is going to qualify for the R&D credit, though.

Under a four-part test, expenses qualify for Section 41 tax credits when the research to discover information is technological and meant to be “useful in the development of a new or improved business component,” and “substantially all” of the process constitutes experimentation.

Businesses most likely to have Section 174 expenses include but aren’t limited to manufacturing, software, engineering, architecture, product development, technology, and breweries, distilleries, and wineries.

Section 174 amortization explained

Beginning in tax year 2022, expenses declared under Section 174 are no longer 100percent deductible. Instead, they must be amortized over five years (unless otherwise noted).

Section 41 tax credits are optional, but reporting and amortizing Section 174 expenses is mandatory. Filing for R&D tax credits can offset some of the heightened tax liability amortization imposes.

Examples of Section 174 expenses that are ALSO eligible for R&D tax credits include:

• Direct research expenses. (Wages, supplies, cloud hosting costs and contract research expenditures (65percent of eligible costs).
• Supervision of research. (Wages. R&D tax credit eligible for direct supervisors.)
• Software expenses.
• Pilot models.
• New processes, formulas, inventions, or techniques.

Examples of Section 174 expenses that are NOT eligible for R&D tax credits include:

• Employee Benefits
• 100percent of contract research expenditures
• Indirect research expenses: Includes rent, utilities, and overhead.
• Foreign research (15-year amortization).
• Depreciation on equipment directly used or allocated to an R&D activity
• Patent-related expenses.
• Research funded by a third party.

How to soften the blow: 4 steps

Under the new rules, businesses reliant on research could see their tax liabilities rise steeply.

For example, a corporation that previously deducted $4 million in research expenses can now deduct only $400,000 in 2022.  If research expenses remain the same over the entire five years of amortization, it will be 2027 until the corporation can deduct $4 million again.

In the meantime, businesses should know the requirements for identifying, capitalizing, and amortizing Section 174 research expenses versus other qualified business deductions covered by Section 162. In the past, there were no incentives to separate deductions claimed under Sections 162 and 174 because both were 100 percent deductible. Still, the amortization requirements now mean you must isolate Section 174 expenses.

The Tax Cuts and Jobs Act of 2017 imposed the Section 174 amortization requirement. While some tax experts still hold out hope lawmakers may yet repeal the requirement, it is far from a sure bet.

One thing all agree on: At this point, follow the law as written.

Experts also uniformly advise filing extensions -- which many businesses have done as they sort through their options and watch for possible repeal. In the meantime, it’s essential to anticipate and plan for all possible outcomes. Consider these recommendations:

• Work with your CPA and tax advisors to project tax liabilities and how to reduce them by carefully reviewing your expenses to determine the proper classification between Section 174 and Section 162. Plan for the next five years, 2022 to 2027, and be prepared for higher taxable income and tax liability, especially initially. Even while they watch the situation balance out in two to three years, many businesses will experience restricted cash flow.  As a last resort, many companies may need to pursue bank funding to help pay for these increased tax bills.
• Offset the spike in tax liability by pursuing the R&D tax credits and looking into all corners of the tax code for other available credits, deductions, or funding.
• Monitor IRS guidance and upcoming legislation, including the proposed American Innovation and Jobs Act, which would repeal amortization. Be prepared for all possible outcomes, from repeal to continued imposition.
• DO NOT skip a year of claiming R&D credits to avoid amortizing Section 174 expenses, especially if you regularly claimed them in the past. This is a major red flag to the IRS and greatly increases your chances of an audit. Do not take that chance. The penalties are severe.

Although the future remains cloudy, we feel confident about counseling clients on what to do and how to prepare for any eventuality. Every business situation is unique, so talking to an expert is crucial.  Stay tuned for more information as this situation continues to develop.

If your business relies on research and development to stay competitive and agile, there’s no need to stumble over Section 174 amortization. Be prepared and stay in compliance by contacting John Allen at Boyer & Ritter, jallen@capbr.com, 717-761-7210.