Few Businesses Can Avoid the Changes to R&D Capitalization Rules

Throughout history, new ideas have reshaped society. The industrial revolution flipped the manufacturing industry on its head, reducing prices on consumer products and requiring companies to change their processes to increase profits. Silicon Valley entrepreneurs developed technology that changed how we communicate both personally and professionally. The development of mRNA technology in the fight against Covid-19 revolutionized the pharmaceutical industry and its development of vaccines.

Because of these changes, all industries have had to spend money on research and development. The cost of R&D played a pivotal part in the Tax Cuts & Jobs Act of 2017, including one provision that took effect about a year ago and will be felt when businesses file their 2022 taxes. The tax implications of this provision and its impact on effective tax rates—and most importantly on cash flow—can’t be ignored.

Since Jan. 1, 2022, all businesses have been required to capitalize their R&D expenditures for tax purposes over a five- or 15-year period. Previously, they were able to expense R&D costs in their entirety during the tax period incurred. When we look at the tax code holistically, companies with large amounts of R&D expenses are affected the most.

First, Section 174 requires the capitalization of R&D expenses, which may put a taxpayer into a taxable income position, thus using a company’s available net operating loss carryforwards. Second, depending on the nature of the company’s financing those same net operating losses that are being used may be limited by Section 382. Those same losses, if generated after Jan. 1, 2018, may only be able to offset 80% of taxable income. Companies facing this set of facts may find themselves paying cash taxes significantly sooner than anticipated and should budget accordingly.

It isn’t all bad news for companies with large R&D expenditures—they can use a credit for increasing research activities, commonly referred to as the R&D credit. Although R&D is to be capitalized under Section 174, for the purposes of the R&D credit, the entire amount of R&D expenses incurred in the taxable period can be used to calculate the available credit.

Let’s not forget the states. The R&D credit may lessen the current period tax liability at the federal level, but state jurisdictions may still be subject to paying cash taxes. The R&D credit at the state level is only available in certain places and only available if the R&D expenses are incurred in that jurisdiction. So, if the expenses are incurred either overseas or in a state with no credit, then there will be no state benefit for those expenses. One item to note: Although most states conform to the federal law, not all states require R&D expenses to be capitalized.

Outside of a company’s tax return, the best place to see the impact of the Section 174(a) changes to tax expense would be within the financial statements. The major deferred tax assets of loss corporations are generally net operating losses, Section 163(j) carryforward, and stock-based compensation. Because the capitalization of R&D expenses is a temporary difference for book and tax purposes, there will be a new deferred tax asset within the tax footnote.

This alone should bear no impact on the effective tax rate, because the increase to a current tax expense would have an opposite reduction on the deferred tax expense. If the capitalization of R&D results in taxable income for the company, the net operating loss & Section163(j) interest carryforward deferred tax assets would be impacted as well.

Going one step further, the implications of having taxable income would influence the attainability of deferred tax assets and historical valuation allowance analysis. For companies that had full valuation allowances on their net operating losses that now expect to use these attributes to offset current period income, there could be an argument to release a portion of the valuation allowance.

To determine the need for a valuation allowance, all available evidence should be considered. Releasing some or all of a valuation allowance would drastically impact the effective tax rate of a company and would need to be explained within the financial statement footnotes.

At first glance, corporate taxpayers may have assumed that the changes to Section 174(a) only impacted life science companies—those with lab coats and test tubes. But after reviewing the definition of R&D, this change will be impacting all industries—and that means you.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Stephen Boncimino is a senior in EisnerAmper’s Corporate Tax Group. He specializes in working with public and private multistate and international corporations and has a strong background in comprehensive tax consulting services.

Alexandra Colman, is a partner in EisnerAmper’s Corporate Tax Group. She serves clients in a variety of industries, including manufacturing, retail and distribution, technology, life sciences, and pharmaceuticals, as well as start-up tech and internet base companies.

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