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Since the Tax Cuts and Jobs Act of 2017, many voices have raised concerns over the treatment of expenses under section 174. I will be the first to admit that in our shop, we wondered about it and had heard the provision would surely be re-written because of the dire consequences to so many taxpayers. We did not raise an alarm, however, because we wanted to know more. For 99% of our clients, we would like to reassure you that it is a non-issue for you. If you are a software development client, we need to talk—unfortunately, your situations are less clear currently.
First, a little background on what we are talking about here: deductions, amortized expenses, capitalized expenses, and credits. Income tax is the tax levied on income. Income is gross income or net income. Net income is the gross income minus the expenditures you can subtract from the amount you will be taxed on. These expenditures that you subtract from income come in two main forms—those that are deducted (100% or partially) and those that were amortized (also called capitalized). The government’s default position is that expenditures are capitalized, which means assigned to a capital account (a log of what you’ve spent or invested in your business). The capital account, at its most basic, will lower your tax liability when the business is sold—the sale price minus the amount tracked in the capital account equals the amount that a tax rate will be applied to (this is a capital gain tax). Some capital accounts are used before the final sale of the business. When the expenditure is broken up over multiple years (typically a 5, 10, 15, or 20 year schedule), this is amortization. When an expense is deducted, it can be a partial deduction (for example, 50% deduction of certain business meals & entertainment expenditures) or it can be 100% of the expense (for example, rent, utilities, phone service, employee wages). Once the tax rate is applied to the net income, the resulting amount is called your tax liability. If you have a tax credit, the amount of the credit is then subtracted from the tax liability. This final figure is ultimately your tax bill.
The standard business deductions are found under section 162 of the Internal Revenue Code. The provision allows on-going businesses to deduct those normal expenditures from their overall revenue to determine their taxable net income. Section 174 was passed in 1954 and specifically allowed less-established business ventures to deduct specified expenditures, namely a defined set of research and experimentation expenditures. Section 41, passed in 1981, governs the R&D Tax Credit. Section 41 uses expenditures, which could also be defined under section 174’s expenditures, but also adds additional restrictions on what section 41 qualifying expenditures are. It is important to understand that section 41 expenditures are not section 174 expenditures, even though there is substantial overlap in defining the expenditures. Formerly, section 174 allowed the taxpayer to choose between a deduction (100% of those costs can be subtracted from any income) or to be amortized (in this case, spread out over 5 years, 1/5 of the amount deducted each year). With the resent changes, those using section 174 only have the latter option to amortize.
To explore the distinction between section 41 and section 174, I will start with a distant memory from my first green days involved in R&D Tax Credit work: we read section 41 and glossed over the part in section 41 that referenced section 174. I asked my supervisor something along the lines of: if we work with a new client, and they have previously never used section 174 for these expenses, and they have been using “normal deductions” (as you would call most everything treated under section 162), do these expenses get recategorized as 174 expenses in order to make it into the credit’s calculation? The answer was, more or less, to move on with the work day as it was a moot question, because section 174 and section 162 allowed the taxpayer to treat them the same and so virtually all taxpayers, since the RTC passed in 1981, had never had to make the call or even contemplate the mechanics of how expenses “enter” into section 41 calculations—assuming the expenses otherwise qualified under the provisions of section 41. Never to my knowledge, has a company been required to conduct a change in accounting method to convert expenses treated under section 162 into expenses treated under section 174 to claim the R&D tax credit. Consistency in methodology and treatment, as well, would indicate to some extent that section 162 expenses remained as such, but were also otherwise qualified as section 41 eligible costs towards the R&D credit calculation.
Fast forward to the closing of tax year 2022, with the amended section 174 really being a point of focus for many CPAs and taxpayers. At Blackland Tax, we have been through the text, the regulations, and the case law, and after all of it, one big question remains for those insisting on mandatory conversion of expenses from section 162 treatment to treatment under section 174: Unless it’s software, where is that coming from?
We know section 41 references section 174, but it is not a barrier to use under section 41. It is applied in reference to the definition of the activities in section 174—namely, when expressly written for the first time into the tax code in 1954, it identified certain experimental and research activities that taxpayers may undertake and subsequently deduct, as it said, “in connection with a trade or business” in comparison to section 162’s “carrying on a trade or business”. To put into layman's terms, before 1954, the IRS used to disallow deducting expenses in your garage start-up, or fledgling business, because you were not carrying on a business, you were not an established business… you were perhaps more akin to Professor Brainard developing flubber, rather than Flubber, Inc. with staff developing the next iteration of flubber.
Here is the reference in 26 U.S Code §41:
§41(d)Qualified research defined
For purposes of this section—
(1) In general
The term “qualified research” means research—
(A)
with respect to which expenditures may be treated as specified research or experimental expenditures under section 174
The IRC goes on into much more depth defining the nature and scope of activities and exclusions for determining qualified expenses for the R&D credit, but that is what section 41 says about section 174: expenditures which may be treated as R&E expenditures under section 174.
At the risk of being too much of a lawyer, and a tax lawyer to boot, “may” means something very different from other words. The expenses that “may” be treated as R&E expenditures under section 174. And it is used in section 41 to help define the types of expenses (like Professor Brainard needed!) that could (formerly) be deducted in connection with a trade or business rather than the carrying on of a trade or business. It is a stricter definition of qualifying expenses (R&E type expenses), but a broader application of which taxpayers are qualified to take these expenses—the taxpayer no longer had to pass the threshold test of being established and carrying on a business, of offering products or services for sale, lease, or license. And so, section 41 leans on and references section 174 for the purposes of defining those expenditures.
Maybe taxes are not your thing. Let’s imagine a weird high school biology class—there’s a cell with a membrane, we’ll call it cell 41. Cell 41's membrane is semi-permeable. Two types of proteins can pass through its membrane--- type 174 proteins that come from the 174 gland or type 174 proteins that come from the 162 glands—which makes proteins of varying kinds, including type 174 proteins. Cell 41 does not require 162 glands to change into 174 glands to produce type 174 proteins. The type 174 proteins that the 162 gland produces already fit through the cell 41's membrane.
We worked through it using a classic tax law class hypothetical format as follows:
Taxpayer ABC is carrying on a trade or business. ABC decides this year to NOT claim the R&D credit. Why? His well-meaning CPA read in an article that all wages will need to be reclassified as section 174 and amortized over 5 years. Therefore, under the CPA's guidance, the section 41 RTC is not claimed and all the wages are treated under section 162. Are they section 162 expenses or section 174 expenses? Making the obvious choice, they are treated as section 162 expenses, as there is no mandatory language to reclassify expenditures under section 174, when the taxpayer carrying on a trade or business may otherwise treat them under section 162.
Taxpayer DEF, too, is carrying on a trade or business. DEF decides to claim the R&D credit. Section 41(d)(1) says "the term qualified research means research (A) with respect to which expenditures MAY be treated as specified research or experimental expenditures under section 174". Expenses in connection with the taxpayer's trade or business treated as section 174 expenses are required to be capitalized under the new law. Expenses incurred in carrying on the trade or business are deductible under section 162. Taxpayer DEF must decide to treat the expenses as section 174 or section 162 expenses. Taxpayer DEF decides to treat them as section 174 and then suffers through the 5-year amortization effects of higher taxes in the beginning years.
Meanwhile, taxpayer GHJ is carrying on a trade or business. GHJ decides to claim the R&D credit. Section 41(d)(1) says "the term qualified research means research (A) with respect to which expenditures MAY be treated as specified research or experimental expenditures under section 174". Expenses treated as section 174 are required to be capitalized under the new law. Expenses incurred in carrying on the trade or business are not required to be capitalized under section 162. Taxpayer GHJ must decide to treat the expenses as section 174 or section 162 expenses. Taxpayer GHJ decides to treat the expenses as section 162 expenses and claim the section 41 RTC credit. Taxpayer GHJ is unaffected by the amortization provisions, therefore, so long as taxpayer GHJ elected to treat expenses as section 162 expenses "in carrying on a trade or business", and not section 174 expenses "in connection with a trade or business" (as would be his choice to make, I assume, for R&E activities qualifying for both treatment under section 174 or section 162, in connection with or in carrying on, respectively).
The choices above would potentially have huge impacts. As an example, imagine an engineering firm with revenues of $1.5 million dollars and $1 million in engineering wages. Assuming all the engineering wages met requirements for both section 162 and section 174, if the $1 million in wages is deducted under section 162, then the engineering firm is paying on a taxable income of $500k. With a 20% tax rate, that puts the regular tax liability (before any credit) for the year at $100k. If the $1 million in wages is amortized over 5 years under section 174, only $200k of the $1 million in wages can be used to reduce income in the first year leaving a taxable income of $1.3 million. With a 20% tax rate, that puts the regular tax liability at $260,000. The effect continues, and in year 5, the situation has pseudo-stabilized with 5 years of 1/5th deductions added together, but the tax bills have been larger for 4 years running.
The questions for anyone concerned about sweeping changes to the R&D credit are:
1.) Is the average taxpayer carrying on a trade or business required to use section 174 for expenses that may be categorized either as section 174 or section 162 expenses? If so, where is that provision in the code? If the taxpayer used an expense type (let’s say, wages) for a section 41 credit calculation previously, but doesn’t claim it moving forward, does anyone posit that this category of expenses is nonetheless required to be treated under section 174 moving forward?
2.) If the barrier to entry for section 41 is expenditures that "may" be treated as section 174 expenses, where does the code require conversion of section 162 expenses into section 174 expenses prior to utilization for section 41 RTC calculation purposes?
My conclusion, by plain reading of the provisions, is that the taxpayer carrying on a trade or business may treat R&E expenses under section 162, or if they wanted to, under section 174 in connection with a trade or business (the looser standard), and that utilizing the section 41 RTC does not preclude or ban the taxpayer from using section 162 treatment of expenses. The crucial piece is meeting the long-standing and well-established standard of carrying on the trade or business-- the stage of holding themselves out as providing the goods or services they started their business to provide. Only new ventures that fail to meet the threshold test of carrying on their trade or business, or software ventures that are specifically targeted under section 174, would fail to have the option between treatment under section 162 or section 174, and thus be forced to use section 174's treatment of amortizing said R&E expenditures.
For further reading, and in case you think my opinion needs more weight, I highly recommend reading “Changing Research Tax Break Rules Will Harm Fewer Than Predicted” by Rick Kleban, Dainer Reinier, and James Bean on Bloomberg.com Bloomberg Law/Bloomberg Tax blog found here:
For clients and CPAs with further questions, please contact me directly for more in-depth information regarding this issue. The above is provided for general educational purposes only and you should always seek the advice of a tax professional for your specific questions or for advice. This article is not legal advice or accounting advice specific to any one person.
Cheers,
Jimmy