Manufacturers Beware: Research Costs Will Soon Be Amortized
posted Oct 29, 2018 by Paul Oliveira, CPA in the Global Tax Blog
To stay ahead of the competition, it’s critical for manufacturers to develop innovative new products and research ways to improve existing ones. That’s why 28% of the respondents to our 2018 Manufacturing Industry Outlook Report are planning to invest 6% or more of their revenue in research and development (R&D) this year — and 18% plan to use their savings from tax reform to pursue R&D initiatives.
Before you launch a major research project, however, it’s important to understand how the rules for deducting these expenditures will change under the Tax Cuts and Jobs Act (TCJA).
Preserving the Research Credit
The TCJA doesn’t alter the research credit that was made permanent and expanded under the Protecting Americans from Tax Hikes (PATH) Act of 2015. The credit is generally based on incremental R&D spending over a base amount that’s a function of your company’s historical R&D expenditures.
The rules for taking the research credit are complicated, and numerous restrictions apply. But it provides an incentive for manufacturers to step up their spending on research.
Options for Research Costs Paid or Incurred before 2022
For R&D costs incurred in a tax year that begins before 2022, the pre-TCJA rules still apply. That is, you can still elect to deduct specific research or experimentation expenses in the year they’re paid or incurred.
For example, assume your company spends $150,000 to develop a new product in 2018. You can elect to deduct the full amount in 2018 under IRC Section 174. Most profitable companies choose this option to offset their tax obligations on existing product lines.
However, you also may forgo a current deduction, capitalize the research expenses, and recover them ratably over the useful life of the research (not to exceed 60 months). Or you may elect to recover them over a period of 10 years.
Capitalizing Research Costs Paid or Incurred after 2021
For R&D costs paid or incurred in tax years beginning after December 31, 2021, you must capitalize and amortize specific research and experimentation amounts over a 5-year period. The amortization period increases to 15 years for research conducted outside the United States. Amortization begins with the midpoint of the tax year in which the expenses were paid or incurred.
For example, assume your company spends $150,000 to develop a new product in the United States in 2022. Under the TCJA, you must amortize that amount over 60 months at $2,500 per month. The amortization period begins with the midpoint of the tax year in which you pay or incur the expenses (July 2022, assuming your business is a calendar-year entity). So, the deduction under Code Sec. 174 for the first year would be $15,000.
Once the new rules go into effect, it will be important to factor the deferred tax savings from research costs into your capital budgeting analyses before pursuing product development initiatives. Taxpayers currently deducting R&E costs in the year incurred will also be required to file an Application for Change in Method of Accounting (Form 3115) to begin capitalizing and amortizing such costs for tax years beginning after December 31, 2021.
Under the TCJA, “specified research and experimentation expenditures” generally include the same type of expenses that are subject to Sec. 174 under prior law, including expenses for software development. But expenses for land or for depreciable or depletable property used with the research or experimentation (except for the depreciation and depletion allowances of such property) are specifically excluded. Also excluded are exploration expenses incurred for ore or other minerals (including oil and gas).
How much does your company plan to spend on R&D in the next few years? It could make sense for some manufacturers to develop new products sooner rather than later — when the capitalization rules go into effect. Contact us for more information about how the new Sec. 174 rules will affect your business or for assistance evaluating your future R&D plans.