Section 174 and Section 163(j) among key tax changes for 2022
As we began a new calendar year, several federal tax changes quietly took effect. During 2021, much of the tax focus was centered around the Build Back Better Act (BBBA), which remains on hold in Congress. However, other tax rules were already set to change based on existing law. Those changes will impact current year tax liabilities and will require consideration prior to the first estimated tax payment dates of 2022. Here are our thoughts on what these changes mean and what might be possible for tax legislation during 2022.
What tax rules changed on January 1, 2022?
The federal tax changes for 2022 come from a variety of sources. Those include changes created by the Tax Cuts and Jobs Act (TCJA) with delayed effective dates, the expiration of many COVID-19 pandemic-related programs, and new types of tax reporting.
- Changes to the treatment of Section 174 research and experimentation (R&E) expenses: One of the most significant tax changes for many businesses in 2022 is a requirement that taxpayers capitalize and amortize their research and experimentation (R&E) expenses paid or incurred after Dec. 31, 2021, under Sec. 174. Previously, taxpayers were permitted to either deduct R&E expenses in the year they were incurred or amortize them over different periods of time depending on the nature of the expenses. However, taxpayers must now capitalize and amortize all R&E expenses. The relevant amortization period is five years for research conducted within the United States or 15 years for research conducted outside of the United States.
- 90% of the tax owed for the tax year, or
- 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 separately), or 110% of the tax owed in the previous tax year for all other individual taxpayers.
- Understand the tax impact of capitalizing Sec. 174 expenses.
- Identify steps that can be taken to prepare for changes to the deductibility of Sec. 174 expenses in their businesses.
- Evaluate methods for tracking Sec. 174 expenses and develop best practices for tracking such expenses apart from other business expenses.
- Model the impact of the required capitalization and amortization on current year taxable income, which may include indirect impacts to GILTI, Sec. 163(j), and other provisions.
- Determine the methodology to be applied for estimated tax projections during 2022, such as calculating the actual impact of Sec. 174 or utilizing a high-level estimate based on assumptions. A related assumption is whether quarterly estimated tax payment calculations will be based on current year or prior year taxable income.
- Modification to the Sec. 163(j) business interest expense limitation: Beginning in 2018, the TCJA required taxpayers to subject annual business interest expense deductions to a limitation based on a percentage of adjusted taxable income (ATI). The calculation of ATI begins with taxable income and includes a variety of additions and subtractions. A core feature of that calculation has been an add-back for depreciation, amortization, and depletion deductions, which facilitated enhanced deductions for asset-intensive businesses. However, in 2022 and subsequent tax years, the computation of ATI will no longer include that add-back.
- Expiration of enhanced charitable contribution deductions: Several charitable contribution deduction rules also expired at the end of 2021. COVID-19 pandemic-related legislation provided increased and expanded charitable deductions in 2020 and 2021. Specifically, these included a temporary removal of the individual charitable deduction limit of 60% of taxable income, an increase in the corporate charitable deduction limit from 10 to 25% of taxable income, and an increase in the business food inventory charitable deduction limit from 15 to 25% of taxable income. It also created a temporary above-the-line charitable donation deduction of up to $300 for individual filers and $600 for married joint filers who claim the standard deduction. Those enhancements have all expired as of Jan. 1, 2022.
- End of the Employee Retention Credit (ERC) for current calendar quarters: The ERC was created by the CARES Act and has been a beneficial, refundable payroll tax credit for businesses that were impacted by the COVID-19 pandemic. Our resource center provides important information for taxpayers who want to take advantage of the ERC. As of the end of 2021, the ERC is no longer available based on any current operations. The general ERC, based on either a partial or full shutdown or a decline in gross receipts, expired on September 30. However, the ERC for recovery startup businesses, which began on July 1, expired on December 31.
- Expanded Child Tax Credit (CTC) and Child and Dependent Care Tax Credit (CDCC): The American Rescue Plan Act of 2021 (ARPA) temporarily expanded the benefits of the existing Child Tax Credit (CTC) and the Child and Dependent Care Tax Credit (CDCC) for middle- and low-income taxpayers. Under the expanded CTC, qualifying households were eligible for fully refundable maximum payments of $3,600 per child under six years old, and $3,000 for all other children. Monthly advanced payments of the CTC were also made to taxpayers between July and December 2021. Beginning in 2022, the CTC payments reverted to partially refundable maximum payments of $2,000 and the advanced payment feature also expired.
- Expanded Earned Income Tax Credit (EITC): The ARPA temporarily expanded the EITC qualifications for taxpayers without qualifying children by reducing the minimum age of eligibility and increasing the maximum payments from $540 to $1,500. These changes are no longer available beginning in 2022.
- Expanded Form 1099-K reporting requirements: The ARPA dramatically lowered the transaction thresholds requiring the issuance of a Form 1099-K, which reports payments received by a taxpayer through third-party payment settlement platform. This will apply to popular websites, such as PayPal, Etsy, and Venmo, among others. Qualifying payments for purposes of Form 1099-K are made for goods and services and don’t include reimbursements, charitable contributions, or other similar transactions. For all qualifying transactions settled on Jan. 1, 2022, or later, the dual reporting threshold of greater than $20,000 in total payments and over 200 transactions will no longer apply. Instead, third-party payment settlement platforms will be required to issue a Form 1099-K to taxpayers for all qualifying payments when the total amount of such payments exceeds $600 in a single year.
Legislative proposals have been introduced to modify the application of Sec. 174. The most recent draft of the BBBA contained a provision that would defer the effective date from 2022 to 2026. However, the BBBA has stalled in the Senate, and any legislative changes to Sec. 174 face a highly uncertain future.
Required capitalization under Sec. 174 will have a pervasive effect on most businesses. In particular, R&E expenses are broadly defined and will even eliminate tax deductions for businesses that are ineligible for the research and development credit under Sec. 41. Our webinar takes a deep dive into those definitional considerations and the expected impact on taxable income. Sec. 174 expense tracking is of great concern, as most businesses haven’t historically tracked such expenses separately from general business expenses. While it’s possible for Congress to defer these rules retroactively, we recommend clients consider the impact of these rules now to prevent future complications related to 2022 income tax filings, including estimated payments and short year returns due during 2022.
The most immediate impact of Sec. 174 will be on quarterly estimated tax payments, beginning with the first quarter of 2022. Corporations and individuals, including sole proprietors, partners, and S corporation shareholders, generally must make quarterly estimated tax payments if they expect to owe tax exceeding $500 for corporations and $1,000 for individuals. If a taxpayer doesn’t remit an accurate estimated tax payment, the IRS may apply an underpayment penalty for each quarter that the taxpayer doesn’t remit an accurate payment of estimated tax. A safe harbor applies to quarterly estimated tax payments for individuals, which requires that each payment captures one quarter of the lesser of:
Large corporate taxpayers are provided a more limited safe harbor only as to the corporation’s first quarterly payment. This first quarterly estimated tax payment may be calculated based on the lesser of the corporation’s tax owed in the previous year or the tax owed for the current year. In order to avoid penalties, large corporate taxpayers who are impacted by Sec. 174 capitalization rules will need to account for those rules in quarterly estimated tax payments no later than the second quarter.
Below are some important steps businesses should consider taking now to prepare for the impact of these changes throughout 2022:
The expiration of the depreciation, amortization, and depletion add-back will reduce the annual interest expense deductions for many businesses. The actual impact will ultimately depend on the amount of those deductions and the general profitability of the business. However, this will certainly reduce the aggregate amount of business interest expense deductions of businesses in 2022. Much like the changes to Sec. 174 expense deductibility, changes to business interest expense deductions must be factored into calculations for quarterly estimated tax payments. Fortunately, this change is a slight adjustment to existing rules, so the implementation process should be relatively simple.
The charitable deduction enhancements allowed taxpayers to reduce their taxable income through planned giving during 2020 and 2021. Following the expiration of these enhancements, taxpayers are left with less generous options for planning 2022 tax deductions. When approaching tax planning and charitable contribution planning for this year, taxpayers should be mindful of the restoration of the 2019 charitable deduction rules.
Although businesses will no longer be able to claim the ERC based on current operations and payroll tax returns, they may continue to retroactively claim the ERC for prior calendar quarters by filing amended payroll tax returns. Such filings are due within three years of the date their respective quarterly payroll tax return was filed or two years from the date they paid the tax reported on their quarterly payroll tax return, whichever is later. Since the qualifying tests and maximum allowable credit changed while the credit was in effect, businesses should reevaluate opportunities to claim the ERC during 2020 and 2021. If taxpayers want to avoid amending the credits claimed on their 2021 federal income tax returns, they should identify any ERC claims they are entitled to and file those claims before they file their 2021 federal income tax returns.
Similarly, the expanded CDCC made the credit refundable and increased the maximum payment for dependent care expenses from $3,000 to $8,000 for one qualifying dependent and from $6,000 to $16,000 for two or more qualifying dependents. Beginning in 2022, the CDCC returned to a nonrefundable credit and the maximum payments were reduced to $3,000 for one qualifying dependent and $6,000 for two or more qualifying dependents.
Taxpayers should plan for the lowered CTC and CDCC payments in 2022. Congress has considered further expansion of these programs as part of the BBBA. However, such legislation faces a challenging future given current developments.
Taxpayers should already be reporting 1099-K payment amounts on their tax returns, but the expanded Form 1099-K reporting will provide increased disclosure to the IRS. This will require taxpayers to exercise additional diligence in verifying that their Form 1099-K amounts are consistent with the income amounts taxpayers are otherwise reporting on their returns.
Will we see other tax changes during 2022?
The short answer is that the path forward for new tax changes is currently uncertain. The BBBA would make significant changes to existing tax rules, if enacted. However, on Dec. 19, 2021, Senator Joe Manchin announced that he “cannot vote to continue” with that bill. Since the Senate is evenly divided, and the BBBA doesn’t have bipartisan support, a “no” vote from even one Democratic senator prevents passage of the bill. In the weeks that followed Senator Manchin’s announcement, Democratic leadership indicated that negotiations on the BBBA would continue, although there have been few concrete developments beyond public statements. These developments stalled the BBBA and raise many questions about whether there is a path forward and what tax changes would be included in the bill if it does advance.
It’s also possible for Congress to change tax rules during 2022 through legislation outside of the BBBA. One category to watch is taxpayer-favorable changes included in the BBBA that might have broader support in Congress (e.g., Sec. 174 modifications). A second category includes enhancements to tax rules that would address perceived gaps in existing law. Many of the proposals in the BBBA outside of the headline items would fall into this second category. Congress might also utilize tax changes to support businesses and individuals in response to either lingering challenges of the COVID-19 pandemic or broader economic concerns. Finally, Congress could alter rules that are set to change or expire on their own.
Tax changes advancing outside of the BBBA would likely be less sweeping in their scope and would instead impact more targeted types of taxpayers in either favorable or unfavorable ways. The process for any of these changes might also be subject to an elongated process, potentially being held until after the 2022 midterm elections. As the year unfolds, taxpayers should continue to monitor potential tax legislation, but the likelihood of significant changes become less likely with each passing day.
Tax rules have been continually modified throughout recent years, so it has been challenging to keep up to date with the current law. The changes that have so far taken effect for 2022 involve rules that have been known for months or years ahead of time. However, the general theme of these changes is a reduction in the available tax deductions for businesses and individuals. Ultimately, this means that taxable income projections will require greater scrutiny for both estimated payments during the year and the timing of when affected tax returns are filed. Sec. 174 is expected to demand the most attention given the work necessary to track expenses and apply the new capitalization and amortization rules. Throughout the coming year, taxpayers should keep these tax changes in mind so they can proactively plan for the impact to their 2022 tax position. Our experts can assist taxpayers in understanding the impact of these changes and develop a plan that makes sense for taxpayers and their businesses.