U.S. manufacturers are the cornerstone of innovation, but an impending tax change threatens to disrupt research and development in this sector – risking thousands of jobs and crucial progress necessary for America’s economic success and national security.
Under Section 174, taxpayers are entitled to expensive deductions for research and experimental expenditures made during the taxable year concerning their trade or business. Section 174 is one of several provisions under the Internal Revenue Code that allow taxpayers to deduct the cost of innovative activity (e.g., R&D) necessary to enhance the taxpayer’s business capabilities and product development and ultimately drive economic growth.
The Tax Cuts and Jobs Act of 2017 significantly changed taxpayers’ ability to deduct research and experimental expenditures under Section 174 of the Internal Revenue Code. In general, the TCJA requires most taxpayers to have a written statement prepared by a certified public accountant or attorney, setting forth the facts justifying why a particular expense is experimental. The message must be attached to the return as an addendum. Failure to adhere to these new requirements can result in disallowance of that deduction on your tax return.
Since the first part of 2022, businesses have found themselves in a new tax paradigm that requires them to spread deductions for R&D expenses over five years rather than taking the entire deduction within the same year. The Code requires taxpayers to amortize research and experimentation expenditures over five or fifteen years. For domestic R&E, amortization begins at the mid-point of the taxable year that the cost is paid or incurred. For foreign R&E, amortization starts in the first taxable year after December 31, 2021. This change impacts the timing of when expenses are reported on the tax return and a reduction of savings from these costs.
Amortizing research and experimental expenditures may be unfamiliar to many taxpayers. To determine whether an amortization change will be necessary, taxpayers should carefully review the types of spending for which the new deduction is available and then decide whether or not they have elected to expense R&E expenses in the past.
The IRS has issued guidance to assist employers in claiming depreciation deductions on property acquired and used differently than previously treated by prior law. This guidance provides administrative relief and allows taxpayers to file a statement with their federal tax return in place of a Form 3115, Application for Change in Accounting Method, provided the change is made in the first taxable year that the new Section 174 guidance is effective (i.e., the first taxable year beginning after December 31, 2021).
In addition, the new procedures provide clear transition guidance for taxpayers that have already filed a federal tax return for a short taxable year for which the new Section 174 guidance was effective. Taxpayers will have additional time to apply the latest procedures and amend their returns as necessary. Taxpayers may use the new methods for any income tax return due more than 90 days after January 19, 2019 (the date on which these guidelines were issued), including an amended return, an original return due after February 8, 2020, or in response to IRS correspondence or notices.
With the implementation of Section 174, taxpayers are not provided with audit protection for research and development expenditures made before the effective date. As Rev. Proc. 2015-13 outlines in its 8.01 section, two approaches can be followed when transitioning to a new method under this provision – one which depends on the timeliness of change sought by the taxpayer.
Statement in lieu of Form 3115
Taxpayers who need to change their method of accounting for the first taxable year beginning on or after January 1, 2022, must file a statement with their federal tax return instead of filing Form 3115. Filing this duplicate copy with the IRS is unnecessary to comply with Section 174 requirements.
A statement for the tax year change is required, explicitly providing name and employer identification number or Social Security Number (as applicable), corresponding beginning/ending dates of tax year changes, and designated automatic accounting method change number #265. Additionally, a description outlining the type of expenditures must be included with the amount paid or incurred likewise specified in this formal request – all to capitalize R&E-related expenses over either five years (domestic research) or fifteen years (foreign research).
By filing a statement, businesses can make all necessary adjustments on an effective date of their choosing – providing more flexibility to companies looking for updated regulations with minimal delay. A temporary waiver has also been issued, allowing taxpayers to adjust accounting methods within just five years without disrupting otherwise established procedures outlined in Rev. Proc. 2015-13.
Taxpayers who have altered their method of accounting for certain expenses within the previous five years can benefit from a waiver on general limitation rules by adapting to new regulations under Section 174. This exemption applies only for taxable years starting after December 31, 2021 – so eligible taxpayers should ensure they’re prepared accordingly.
Form 3115 is required when
Taxpayers whose taxable year has changed after December 31, 2021, must use Form 3115 to adjust their method of accounting. More than submitting a statement for the first fiscal period after that date is required. Instead, utilizing the specialized form will ensure that changes are appropriately applied and accounted for.
Companies needing to compute a modified Section 481(a) adjustment due to specified R&E expenditures paid or incurred in years past must ensure that the eligibility rule of Section 5.01(1)(f) is respected, meaning no changes related to Section 174 have been made within the prior five taxable years. To continue with such adjustments, filing a duplicate copy on Form 3115 according to requirements set by Rev. Proc. 2015-13 will be necessary for proper processing and approval from IRS authorities.
Rev. Proc. 2023-11 offers valuable administrative relief to help taxpayers adjust their compliance with the new Section 174 capitalization and amortization regulations in the first taxable year after 2021. To take advantage of this simplified approach, it is crucial to begin evaluating current processes for identifying applicable costs now to achieve a smooth transition when the updated rules go into effect.
How should you prepare?
The change has put manufacturers and other enterprises into unchartered waters of budgeting amid an ever-evolving business landscape.
With longstanding policies suddenly shifting, companies are now confronted with the daunting task of overcoming this drastic change. Company leaders must allocate more resources when tax demands are rising, limiting the potential for future expansion.
Companies are fearful that the tax change could come at a steep price – reducing profits and putting essential benefits for employees in jeopardy. With an expected decrease in cash flow, teams across manufacturing sectors are bracing themselves as cuts may be necessary to protect paychecks and employee benefits from taking too big of a hit. The reverberations of this potential policy shift can’t be understated; its adverse effects will reach every aspect of business operations.
In such a fast-moving industry, staying competitive requires constant innovation, which demands continuous investment in new products and processes. A significant percentage of a company’s revenue typically goes back into R&D annually. This allows them to stay ahead of their competitors and continue to provide customers with the best possible experience.
Manufacturers are asking Congress to allow them to immediately deduct these expenses as they have for the last 70 years, as some companies can’t make it five years without the ability to deduct the R&D expenses immediately. If you’re curious about the Section 174 amortization changes, please check out this link.
With the ever-changing landscape, guidance, and policies, please feel free to reach out to our team of manufacturing advisors. We are here to serve you and your industry and help you be profitable. Taxpayers should keep their eyes on the horizon for formal guidance regarding new Section 174 rules. This will be an essential resource to navigate any unfamiliar obligations.