174 R&E Expense Amortization and R&D Credits: What All Taxpayers Need to Know

By Justin DiLauro, Chief Quality Officer 

The morning of Tuesday, December 20^th, the Omnibus Appropriations Package was released and likely the last bill that will be passed into law by the 117^th Congress before the new Congress starts the first week of January.  In addition to certain tax extenders absent from this package, the 174 R&E Amortization “Fix” failed to make it in this bill. 

With history as our guide and considering the potential widespread negative taxpayer implications, it remains still highly likely that the 174 “Fix” will be enacted in the early stages of the next Congress and likely by mid-February 2023.  However, with time approaching midnight on this issue and with the IRS readying its potential enforcement of the current requirement to amortize Section 174 Research & Experimental (R&E) Expenses beginning in Tax Years 2022 with last week’s issuance of Revenue Procedure 2023-08, all prudent business taxpayers and their outside accountants should at least begin assessing the situation in the small chance no fix comes by mid-April if they haven’t already. 

Non-R&D Credit Claimers May Be Impacted As Well 

First, it must be pointed out that the impending Section 174 Amortization will apply to both claimers of R&D Tax Credits, and those that have not been claiming R&D Tax Credits – whether by electing out of previous R&D claims or not being eligible for Section 41 treatment.  As such, Section 174 Amortization is not only an issue that has to be addressed by taxpayers that have been claiming (or are considering to start claiming) R&D Tax Credits, but for many other taxpayers as well. 

Specifically, while related, Section 174 R&E Expenditures are not the same amount as Section 41 Qualified Research Expenses (QREs), for which form the basis for the Section 41 R&D Tax Credit.  Section 174 R&E Expenses are the broader category of expenses, as Section 174 specification is one of several requirements to be constituted Section 41 qualified research for R&D Tax Credits, and also, Section 174 would not be limited to only taxable wages, non-depreciable materials, and only sixty-five percent of third-party contractor payments, as Section 41 QREs are.  Furthermore, the project-based requirement for qualification and expense nexus, the exclusions (most notably, the “funding” exclusion for certain T&M or Cost-based contracts), and other items further make Section 41 QREs a narrower category than 174. 

In other words, you could have Section 174 R&E Expenses even if you don’t have Section 41 QREs or R&D Credit claims.  Before Tax Year 2022, 174 R&E Expenses have just been inherently buried within other Deduction categories, such as Salaries and Wages, Costs of Goods Sold, and Other Deductions.  This is problematic because, unlike Section 41 R&D Credits, taxpayers cannot elect out of Section 174 Amortization starting in Tax Year 2022, it is a requirement. 

As such, all taxpayers, R&D Credit claimers and non-claimers alike would be faced with Section 174 R&E Amortization and its impacts. 

Initial Impacts of 174 Amortization with No “Fix” Are Sizable 

With an understanding that the 174 R&E Expenses are broader than 41 QRES for R&D Credits and the amortization is a requirement and not an election, it is important to further examine the potential impacts if Congress does not “fix” this issue in the relatively near future.  Under the new rules starting with Tax Year 2022 as they are currently enacted, taxpayers are required (“shall”) amortize their Section 174 R&D Expenses over five (5) years using a half-year convention.  Meaning, instead of an immediate 100% deduction in the year in which an expense occurred, taxpayers will only be allowed to expense ten percent (10%) in year 1, and then twenty percent (20%) in each subsequent year until exhausted (year 6 deducts the final 10%) for its 174 R&D Expenses. 

As an illustration of these impacts, consider the example below of a hypothetical taxpayer with $1,200,000 of annual 174 R&E Expenses, of which $1,000,000 are also Section 41 QREs for an R&D Credit.  As detailed in the table below, the required Section 174 R&D Amortization has no impact on the Section 41 Credit, but it has a significant impact on tax liability of a taxpayer for the first few years. 

Example Sec. 174 R&E Expense Amortization Impact – First 6 Years

Taxpayers Cannot Ignore 174 Amortization and May Not Simply Say ‘Zero’ for R&E Expenses 

Unlike the 41 Credit, the treatment of expenses as Section 174 Amortization starting in Tax Year 2022 is a requirement and not an election.  As such, the immediate reaction to just not claim R&D Credits any longer misses this point, on top of the fact, again, this is a separate and more broad section in Section 174. 

Furthermore, it does not matter if you elected to claim R&D Credits in the past or not, so cursing any prior decision to start annual R&D Tax Credit claims is misguided as well.  You could have opted out of R&D Tax Credits years ago, but you would still be faced with this Section 174 R&E Amortization requirements now (without the benefit of the credits for the past several years). 

FEAR NOT!!!  A 174 “Fix” is Highly Likely but Taxpayer Should Still Assess Now 

This new treatment of Section 174 R&E Expenses seems gloomy and daunting, but again, R&D Tax Credit Experts, including the Partners and tax professionals at BRAYN, remain highly confident in the “fix”, and Congress reinstating the ability to immediately deduct 100% 174 R&E Expenses by mid-February.  The reason for the optimism is the original reason for the Section 174 Amortization was to better balance the Congressional Budget Office (CBO) score, so the Tax Cuts and Jobs Act (TCJA) of 2017 appeared less costly to the public when passed five years ago. 

In keeping with the 1–2-year temporary R&D Tax Credit tax extender for the first three-and-a-half decades of the R&D Credit’s history, it would be highly likely that Congress does the 174 “Fix” by mid-February, so we should have a nice Valentine’s Day gift from Congress, instead of Christmas gift this week.  Like several of the previous R&D tax extenders, we would expect this to be entirely retroactive to the 2022 tax year. 

This “fix” continues to have strong, broad, and increasingly vocal support from industries large and small and across different verticals, which further increases the likelihood of the “fix” within the first quarter of next year.  With that in mind, it is not to say that all taxpayers, whether claiming R&D Credit currently or not, should not immediately consult with their CPA and other tax advisors as to the appropriateness of a Section 174 Impact Assessment, if nothing more than to have some estimated numbers of potential tax impacts to communicate to lawmakers (particularly on small to mid-sized privately held businesses), so that a “fix” would be passed as soon as possible. 

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.