By Justin DiLauro, Partner, Chief Quality Officer, and Geoff Garber, Partner
Valentine’s Day has come and gone, and still no love from Congress on fixing the Section 174 Amortization issue. As discussed in the blog, “174 R&E Expense Amortization and R&D Credits: What All Taxpayers Need to Know,” taxpayers must amortize their Section 174 R&E expenses over a five-year period as opposed to immediately expensing 100% starting in the tax year 2022. The change will have significant negative tax impacts on a sizable portion of the business taxpayer population.
Now at the end of February 2023, the good news is that Rep. Ron Estes (R – Kansas 4th) will likely be introducing a bill next week that includes the “174 Fix” and allows for the ability to expense Sec. 174 R&E Expenses 100% in year one and retroactively to tax year 2022. This proposal has strong bi-partisan support in both houses and is expected to pass later this year when Congress takes up the debt ceiling.
The good news is there is optimism that the 174 Fix will be passed before any December year-end filers would need to file the 2022 tax returns on extension in September or October of 2023. The bad news is taxpayers still need to determine estimated payments in April at a minimum, with many taxpayers that must file timely by March 15 or April 18 for various reasons.
To summarize some of the discussion of our prior blog, Section 174 R&E amortization requirements differ from Section 41 R&D Credit in several ways, but most specifically:
1. Sec. 174 amortization is a broader scope of both defined activity and category of expense as compared to Sec. 41 Credits.
2. Sec. 174 amortization is a requirement, unlike the Sec. 41 Credit which is an electable incentive.
As such, it is not as simple as just changing your position on Sec. 41 Credits. In some cases, an adjustment as to the Section 41 position could be warranted, but many taxpayers will need to review their expenses and determine what amounts should be amortized per Section 174. If not, they could be left with an uncertain tax position and potentially subject to interest and failure to pay penalties, or worse, substantial understatement penalties.
Section 174 R&E expenses are broader in scope as compared to Section 41 qualified research expenses (QREs). Section 41 limits the expense categories for the R&D credit to four eligible buckets: taxable wages, non-depreciable supplies, 65% of third-party labor, and computer rental). However, Section 174 does not limit the category of expenses and could include most expense categories, including much of the labor burden.
Taxpayers should work closely with their accountants, tax return preparers, and specialty tax providers about how to minimize the negative impacts of the changes and explore areas in which Section 174 R&E Expense determination can be appropriately limited. This analysis becomes increasingly complex the more one dives into the details, but some areas of opportunity, case-by-case, could be the careful categorizing of certain expenses as Costs of Goods Sold (COGS) or the careful delineation of Sec. 41 QREs that are captured pursuant to direct support, direct supervision, or other areas where Sec. 41 may not overlap with Sec. 174.
As mentioned, the “174 Fix” is coming with high probability but likely not until after April 15th. For many taxpayers, the option to extend to a September and/or October filing for 2022 tax returns may be an easy decision. With an extension, a taxpayer can estimate tax and pay in the expectation under the current law or not pay in the additional amounts and potentially be subject to penalties and interest for understating later if the tax law is not changed. However, some taxpayers may be ready to file and pay under current 174 amortization rules before the 174 fix by March 15th or April 18th. The thought, perhaps, is to file as the law currently stands now and then just amend later this year to obtain a refund.
That may be the intuitive answer, but tax administration is not often intuitive. If a taxpayer files under current rules and then Congress does the 174 fix before the extension deadline, taxpayers would possibly need to file a change in accounting on the 2023 federal tax return due in March or April 2024 to go back to 174 year 1 expensing for 2022. This means that taxpayers may have to wait until next year to correct, as the most recent IRS Revenue Procedures only discuss the implementation of the current law, not how it will be handled on a hypothetical fix. Alternatively, taxpayers who file an automatic extension of time may be eligible to file a superseding return before their extended deadline with the 1-year expensing included. Superseding returns take the place of the original return as opposed to editing the prior year return, which is a better scenario for taxpayers and likely a more straightforward process than amending after the extension deadline.
The IRS could issue procedures to streamline the change of accounting process, but months-long delays could still be expected for revenue procedures after the 174 fix is enacted. Regardless, the take home is the tax mechanics and compliance may not be as simple as a traditional amendment for refund, should a taxpayer need to file now and implement the 174 fix later. Much like the 174 expense determination, such a decision to extend a tax return considers many business factors and should be made in close consultation with a taxpayer’s CPA, tax return preparer, and other advisors.
Due to the 174 amortization issue, architecture, engineering, and construction (A/E/C) companies have renewed interest in the Section 179D Energy Efficient Commercial Building Deduction. Since the 174 amortization requirement would mean a loss of deductions, 179D could help mitigate that impact for certain A/E/C businesses, especially since the recent Inflation Reduction Act improved 179D to apply to non-profit and tribal government projects, in addition to projects owned by federal, state, and local governments. Additionally, the IRA increased the deduction amount from $1.88 per square foot in 2022 to upwards of $5.00 per square foot for buildings placed in service starting in 2023.
Companies face uncertain times with the 174 amortization issue, but now is the time to consult with accountants and specialty tax providers to understand the potential impacts. Reach out to BRAYN to discuss your situation today.
IRS Circular 230 Disclosure – To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.