Changes to the R&D Tax Credit in 2022
2022 brought significant developments to the tax treatment of Research & Development (R&D) costs. There was significant activity regarding the timing of deductions, reporting requirements for amended tax returns and proposals for reporting in future tax years. This article highlights key developments and their details.
Section 174 Amortization of Research and Experimental (R&E) Expenditures
As part of the Tax Cuts and Jobs Act of 2017 (TCJA), IRC Section 174 was amended for tax years beginning after December 31, 2021. Taxpayers may no longer expense R&E costs but are now required to amortize their R&E expenditures and software development costs. This is a drastic change to the treatment of R&E expenditures from deducting these costs in previous years to now capitalizing and amortizing these costs.
For R&E expenses incurred in the U.S., these costs are now capitalized and amortized over a five-year period with a mid-year convention. For the first tax year, taxpayers are limited to a deduction of only 10% of their R&E expenses incurred in the tax year.
For R&E expenses associated with activities outside of the U.S., these costs are now capitalized and amortized over a 15-year period with a mid-year convention. For the first tax year, taxpayers with offshore R&E costs are limited to a deduction of only 3.33% of their R&E expenses incurred in the tax year.
To address the transition to these capitalization and amortization rules, the Internal Revenue Service (IRS) released Rev. Proc. 2023-11 in December 2022. Rev. Proc. 2023-11 provides guidance on automatic procedures for taxpayers to change their accounting methods to implement the new IRC Section 174 capitalization and amortization requirement. This guidance simplifies the process to adopt the new accounting method. Taxpayers can file a statement with their federal tax returns instead of filing a Form 3115 (Application for Change in Accounting Method). The statement may be filed by taxpayers in their first taxable year beginning after December 31, 2021. The statement must contain:
- The name and employer identification number or social security number of the taxpayer
- The beginning and ending dates of the first taxable year in which the change to the required IRC Section 174 method takes effect for the taxpayer
- The designated automatic accounting method change number for this change (265)
- A description of the type of costs included as specified R&E expenditures
- The amount of specified R&E expenditures paid or incurred by the taxpayer during the year of change
- A declaration that the taxpayer is changing the method of accounting for specified R&E expenditures to capitalize such expenditures to a capital account and amortize such amount over either a five or 15-year period beginning with the mid-point of the taxable year in which such expenditures are paid or incurred
- A statement that the above-listed changes are being made on a cut-off basis
Rev Proc 2023-11 and the TCJA amendment to IRC Section 174 provide that the accounting method is changed by taxpayers using a cut-off method. That is, only new costs paid or incurred in tax years beginning after December 31, 2021, are subject to the new amortization requirement. R&E expenditures in prior tax years will continue with the accounting method applied in those years.
Taxpayers with a year of change later than the first taxable year beginning after December 31, 2021, are required to file a Form 3115 to change their methods of accounting (with an attachment that contains similar information described in points above).
Additionally, Rev Proc 2023-11 provides transition rules for taxpayers that have already filed a 2022 Federal tax return on or before January 17, 2023 (for a short taxable year in which the new IRC Section 174 guidance was effective).
Inflation Reduction Act of 2022 Changes to R&D Tax Credit
In addition to creating and renewing many energy incentives, the Inflation Reduction Act (IRA) doubled the amount of the IRC Section 41 Credit for Increasing Research Activities (R&D Tax Credit) that could tax offset payroll taxes for qualified small businesses. With a $500,000 cap, this credit is in effect for tax years beginning after December 31, 2022.
Previously, qualified small businesses could utilize their R&D tax credits to offset the 6.2% employer portion of Social Security payroll tax liability up to $250,000. The IRA provides an additional $250,000 that can be used to offset the 1.45% employer portion of Medicare payroll tax liability.
It is important to note that the eligibility requirements for the R&D payroll credit did not change. These requirements are as follows:
- The gross receipts of such entity for the taxable year are less than $5,000,000
- The taxpayer did not have gross receipts for any taxable year preceding the five taxable year period ending with such taxable year
- The payroll credit can only be claimed up to five years
Research Tax Credits Claimed on Amended Returns
As of January 10, 2022, in addition to filing the Federal Form 6765 (Credit for Increasing Research Activities), the IRS required taxpayers to provide the following information:
- The identification of each business component to which the IRC Section 41 research credit claim relates (i.e., a list of the R&D projects)
- The research activities performed for each business component
- The names of the individuals who performed each research activity
- The information each person sought to discover
- The total qualified employee wage expenses, total qualified supply expenses and total qualified contract research expenses for the claim year
The IRS has extended the one-year transition period for an additional year, through January 10, 2024, during which taxpayers will have 45 days to perfect a Research Credit claim for refund prior to the IRS’s final determination.
The significant reporting change and disclosure requirements for refund claims require taxpayers to conduct an R&D tax credit analysis to appropriately document the qualifying research activities. It is recommended that technology companies that have not previously performed a detailed study of their qualified research expenses should contact us for a review.
Please reference to the IRS Section 41 Claims Frequently Asked Questions for more information.
Proposed Changes to Form 6765
The IRC Section 41 R&D Tax Credit was made permanent as of January 1, 2015. The IRS’s evaluation and focus on the credit, however, is ever evolving as cases are litigated and industries mature. To improve the administration of the credit, the IRS has proposed changes to Federal Form 6765 to potentially commence for the 2023 tax year. Similar to the new requirements for R&D Tax Credit refund claims on amended returns, the proposal contemplates including the following:
- The business components for the research tax credit being claimed
- Whether the taxpayer is a member of a controlled group of companies
- The amount of qualified wage research expenditures coming from compensation of officers
- Any acquisitions and dispositions occurring during the tax year
- Any new category of activity or activities being claimed in the tax year
- Whether the taxpayer is relying on the Topic 730 directive as part of its claim
The proposed changes to Form 6765 are not final and the IRS is seeking taxpayer input with anticipated release date of mid-2023.
CHIPS Act of 2022
The Creating Helpful Incentives to Produce Semiconductors and Science (CHIPS) Act of 2022 provides many companies with an additional opportunity to save money based upon investments in semiconductor manufacturing technology. Though not traditionally considered related to the R&D tax credit, many companies who take advantage of the R&D tax credit can also avail themselves of the incentives provided. Similar to the R&D tax credit, the CHIPS Act was designed to foster development and encourage manufacturing activity within the U.S.
The CHIPS Act provides:
- $52.7 billion dedicated to semiconductor research, development, manufacturing and workforce development ($39 billion dedicated to manufacturing incentives)
- $2 billion dedicated to automobile and deference systems legacy chips
- $10 billion allocated to regional investment and technology hub investment
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