Planning for potential changes to Section 174 research and experimental expenses
Beginning in 2022, taxpayers may face a major change to the tax treatment of their business’s research and experimental (R&E) expenses. A provision of the Tax Cuts and Jobs Act (TCJA) is set to take effect on Jan. 1, 2022, requiring taxpayers to make significant changes to the way they treat R&E expenditures under Section 174 (Sec. 174 expenses). A provision delaying the effective date of these changes has been proposed in Congress, but if the proposal isn’t passed, taxpayers need to be prepared to implement the new requirements in 2022.
Section 174 expenses include direct research expenses, such as wages and supplies, as well as certain indirect research expenses such as overhead and administrative costs related to research activities. Currently, taxpayers may deduct Sec. 174 expenses in the year they are incurred. If the TCJA provision remains in effect, for tax years beginning Jan. 1, 2022, or later, taxpayers will no longer be able to deduct these expenses and must capitalize them over a period of five years for research conducted within the United States or 15 years for research conducted outside of the United States. You can learn more about the detailed direct and indirect impacts of this change in our webinar.
Preparing for changes to Section 174 expenses
Switching from deducting to capitalizing Sec. 174 expenses will impact taxpayers’ quarterly estimated tax payments in 2022. Since current tax return forms don’t require separate reporting of Sec. 174 expenses, many taxpayers don’t separately track these expenses and include them as general business deductions. Depending on the unique facts of a taxpayer’s business, capitalizing Sec. 174 expenses may significantly impact taxable income, which in turn will impact the amount taxpayers should be remitting to the IRS in their quarterly estimated tax payments. Taxpayers should review their finance and accounting procedures for tracking and recording Sec. 174 expenses so they can estimate the impact to their taxable income at the time estimated tax payments are due.
Accuracy matters for Section 174 calculations
Corporations and individuals, including partners and S corporation shareholders, must remit quarterly estimated tax payments if they expect to owe tax exceeding a specified threshold. The IRS may apply an underpayment penalty for each quarter that taxpayers don’t remit an accurate payment for estimated tax in their quarterly estimated tax payments. A safe harbor applies to the calculation of estimated tax payments related to the income of individual owners of pass-through entities. Each quarterly payment must capture one quarter of the lesser of:
- 90% of the tax owed for the tax year.
- 100% of the tax owed in the previous tax year for individuals with an adjusted gross income below $150,000 or $75,000 if married filing jointly.
Large corporate taxpayers are only permitted a safe harbor for the corporation’s first quarterly payment, which may be calculated based on the lesser of the corporation’s tax owed for the current year or the tax owed in the prior year. Therefore, in order to avoid an underpayment penalty, large corporate taxpayers must be able to include an estimate of the impact of Sec. 174 capitalization in estimated tax payments no later than the second quarter.
Start planning for 2022 now
While it’s still possible for the effective date of this provision to be deferred, changes to the treatment of Sec. 174 expenses are slated to go into effect on Jan. 1, 2022. It’s important for taxpayers to have a clear plan in place for how they will identify and track Sec. 174 expenses going forward in time to make accurate estimated tax payments. Our experts can help by:
- Developing best practices for tracking Sec. 174 expenses.
- Identifying steps businesses should be taking now to prepare for changes to Sec. 174 deductibility.
- Modeling the impacts to businesses of no longer deducting Sec. 174 expenses.