An unpopular provision of the 2017 tax reform bill that disallows immediate expensing of research and development costs has created a cash flow issue for small- and medium-sized companies unaccustomed to spreading out their deductions, according to a subject matter expert in the R&D space.
Background. Prior to the Tax Cuts and Jobs Act (TCJA; PL 115-97), taxpayers had the option to deduct the full amount of specified research or experimental (SRE) expenses in the year they were incurred under Code Sec. 174. The TCJA included a provision requiring mandatory capitalization and amortization of SRE over a five-year period for domestic expenses and 15 for foreign expenses. Mid-year rules provide that only half of the available deduction can be taken in the first year, with the last added in the sixth or 16th year. Although the TCJA was enacted in 2017, the changes to section 174 became effective starting tax year 2022.
‘Caught off guard.’ One may think that a several-year phase-in window would be “plenty of time for businesses to prepare,” but that “wasn’t really happening,” Moss Adams Partner Travis Riley, who is a leader in the firm’s R&D practice, told Checkpoint in an interview. The expectation among companies, industry veterans, and lobbyists was that the provision would be repealed before actually taking effect due to collective pushback from stakeholders who rely on immediate deductions to get new R&D projects off the ground.
In his experience, companies were “caught off guard” when that option officially went away, with many “just in disbelief that this could happen,” Riley said. For many small and medium taxpayers, especially those in the tech sector, the change means tax liabilities for years where there may have been none under the previous regime. The impact on this group is “significant,” as they are “getting crushed” by the capitalization/amortization requirement, he added.
“They don’t have the money to pay these tax bills. They’re taking personal loans … they’re struggling to survive at this point.”
Cutting costs. On paper, it could be expected that the Code Sec. 41 credit for increasing research activities would become more valuable as a means for mitigating higher tax liabilities, but “you’re seeing the opposite,” Riley explained. Companies are more concerned about not getting caught in a negative cash flow situation and simply “don’t care as much about the R&D credit.”
Since the provision took effect, smaller businesses have had to resort to “draconian measures” to cut costs, including staff layoffs, hiring pauses, and easing up on projects already in the works, he continued.
Salaries for software developers and engineers, for example, fall in the bucket of expenses that must be spread out over six years (for domestic payroll). Because of the “mid-year convention, the year-one deduction is only 10%,” he illustrated. “The next year you incur the costs … [they] are spread out over six years again.” Taxpayers are “used to deducting 100% of the salaries and all of a sudden they can only deduct 10%.
“Some owners may draw from their retirement funds or even consider “moving their operations out of the US completely.”
IRS guidance. In September 2023, the IRS released interim guidance in Notice 2023-63 for taxpayers to rely on while the agency works on forthcoming proposed regs. Though not entirely comprehensive, the guidance addresses several requested areas, including various definitions — such as for research or experimental expenditures and computer software; costs that are and aren’t incidental to SRE activities; and foreign research.
Generally, Riley believes the notice “was super helpful,” but there are certainly lingering questions. Confusion remains, for instance, around “controversial” topics like research performed under contract. The guidance provides that a “research provider” is the party that enters into contracts with a “research recipient” to perform research services on an SRE product or develop an SRE product.
According to Riley, some public commenters have told Treasury that research performed under contract rules “should be just based on financial risk and not on rights. But I’ve seen it argued the other way, where some companies want it to be a rights-based rule.”
There is “a lot of hope” that future guidance would provide “some kind of reprieve” or perhaps exempt government contractors “that don’t have any financial risk” but now find themselves with “a huge tax bill” after spending money received from the government.
Pending tax bill. On January 31, 2024, the House passed the Tax Relief for American Families and Workers Act of 2024 (HR 7024) by a margin of 357-70. Among the bill’s provisions for business taxpayers is a postponement of the TCJA’s mandatory capitalization and amortization requirement through December 31, 2025.
“Therefore, taxpayers may deduct currently domestic research or experimental costs that are paid or incurred in tax years beginning after December 31, 2021, and before January 1, 2026,” read a technical summary of the bill, which has not yet been taken up by the Senate.
Riley emphasized that while many provisions of the TCJA are temporary and set to expire in 2025, its amendments to section 174 are permanent. The Tax Relief for American Families and Workers Act’s ‘fix’ would be temporary, so it is uncertain how much short-term investment would be spurred since taxpayers would find themselves back at square one in 2026.
He forecasted a potential “sugar high” involving companies taking advantage of a temporary return of immediate expensing. “But come 2025, they’re going to be putting projects on hold again.”
What businesses are saying. Many in the R&D community support the full repeal of the TCJA’s removal of the immediate deduction option. In April 2023, a coalition of nearly 600 small software companies sought help from the top taxwriters in the Senate Finance Committee, echoing many of Riley’s observations.
“We are now facing difficult choices because of the large, unexpected, and unprecedented tax liability that we face,” read the letter. “For example, many of us have frozen hiring or suspended projects. Some of us are now considering laying off staff or reducing salaries. Others are borrowing to pay our taxes, either from credit cards, personal savings, or lines of credit.”
Fast forward a year later and that group has almost doubled its number of small business owners, who in a follow-up letter to Senate party leadership shared they were encouraged by the House’s bipartisan approval of the now-stalled tax legislation.
“Since Section 174 amortization took effect, R&D spending nationwide has slowed, turning negative the last two quarters,” they wrote on March 6. “Simply put, we’re in an R&D recession.”
Get all the latest tax, accounting, audit, and corporate finance news with Checkpoint Edge. Sign up for a free 7-day trial today.
