A change is on the horizon for companies that expense R&D costs as incurred. Those expenses may no longer be eligible for an immediate deduction unless Congress passes House Resolution (HR) 1304, American Innovation and R&D Competitiveness Act of 2021, or takes other legislative action to repeal the current law.
What does that mean for your business? Current law requires companies to capitalize all of their R&D costs, including software development costs, incurred in tax years beginning after December 31, 2021. This means that beginning in 2022, your company would no longer be permitted to deduct R&D expenses in the year they were incurred. Instead, you would be required to amortize those expenses over five or 15 years.
If Congress doesn’t repeal the current law, there could be significant impact to your company financial statement and cash flows—particularly for technology and life sciences companies that conduct a significant amount of R&D.
Your business will benefit from having a plan in place if no action is taken by Congress and the current law stands. Below are five best-practice, tax-planning actions to take in light of this uncertainty.
Background on R&D Tax Law
Historically, the US government encouraged businesses to perform their R&D activity onshore, allowing immediate expensing of these costs in addition to a tax credit.
The 2017 tax reform law, commonly referred to as the Tax Cuts and Jobs Act, eliminated the expensing of R&D costs beginning in 2022, however. In response, bipartisan legislation was introduced on February 24, 2021, in the US House and Senate to repeal the current law. Nearly 80 members of Congress have signed the bill as co-sponsors as of August 31, 2021. The prospects for this legislation are uncertain.
Example of How Capitalizing R&D Affects Cashflow
Imagine a company has $10 million in revenue and spends $100 million offshore on drug development.
Traditionally, the company would have a $90 million taxable loss. When the standing law goes into effect in 2022, however, the company could have $6.7 million of taxable profit instead.
This illustrates how capitalizing R&D will have a financial statement impact: What you’re deducting for R&D costs may not be deductible for tax purposes.
It’s important to understand the significant impact that the current law could have when accounting for income taxes—also known as Financial Accounting Standard Board (FASB) Accounting Standards Codification (ASC) Topic 740—on financial statements.
How Could You Prepare for R&D Capitalization Changes?
Unless the current law is repealed, companies will have to amortize R&D costs for tax purposes over five years if the R&D activities are performed in the United States or 15 years if the activities are performed outside of the United States.
If your company incurs R&D costs and you’ve been expensing those costs on your tax returns, consider the following:
- Cash flow planning
- FASB ASC Topic 740
- Documentation of R&D tax credits
- Accounting method links
- Technical accounting
1. Cash Flow Planning
If your company has revenue, limited loss carryforwards, and tax credits—as well as significant R&D costs—consider the cash flow impact of the potential tax burden on your projections. One option is to optimize cash flow tax planning.
Verify what federal and state loss carryforwards are available. Federal loss carryforwards may be subject to 80% taxable limitations. Additionally, if your company has loss carryforwards in California, consider the impact of Assembly Bill 85, which suspends the utilization of net operating losses for taxpayers with taxable income of more than $1 million.
2. FASB ASC Topic 740
Consider the impacts of accounting for income tax (ASC 740) when you capitalize R&D costs. In particular, how it can affect your company’s:
- Deferred tax assets
- Cash taxes
- Effective tax rate
- Bottom line when considering Biden tax proposals
What Is the FASB ASC Topic 740?
ASC 740 requires businesses to analyze and disclose income tax risk. It’s a way to recognize a company’s income tax expense for financial reporting according to US generally accepted accounting principles (GAAP).
3. Documentation of R&D Tax Credits
Often, a company will claim R&D credits on their tax returns, but it neglects to add supporting documentation. Consider documenting your R&D credits to IRS standards if you haven’t already done so; you may need to utilize them earlier than anticipated.
Also, consider reviewing your R&D tax credits to get the most from the amount claimed.
4. Accounting Methods
Consider accounting methods when looking at tax compliance considerations for favorable tax accounting method changes, such as accelerating deductions or deferring revenue.
Accounting method changes also offer the opportunity for taxpayers using an impermissible method of accounting to correct the method and defer cost of the correction over four years while protecting against prior-year audit adjustments subject to interest and penalties.
The choice to make these accounting method changes should be part of an overall cash flow strategy.
5. Technical Accounting
Consider technical accounting for your R&D cost centers and accounting policies to identify costs that could be recategorized as other general and administrative costs.
Each of these five considerations should be assessed when you conduct an R&D study or file a method change. Those actions can help provide cash savings and positively impact your cash-flow forecast as you prepare for coming changes.
We’re Here to Help
If you have questions related to R&D capitalization and the strategies available to your organization, contact your Moss Adams professional.