What You Need to Know About the Capitalization and Amortization of R&D Costs Under the New IRS Regulations

The new provisions in Section 174 of the Internal Revenue Code have led to significant changes that will affect businesses. These provisions mandate the capitalization and decline of Section 174 (R&E) costs for tax years beginning on or after Jan. 1, 2022. Domestic R&E costs will decline over five years, while foreign R&E costs will decline over 15 years. These costs include labour costs, supply costs, amounts paid to third-party contractors, and overhead costs that are incidental to R&E. Previously, businesses received favourable treatment for these costs either as an ordinary business expense deduction or as a reduction of gross receipts.

The new regulations mean that business can no longer immediately expense their costs for employees engaged in R&E activities. This has led to in a significant tax bill for many businesses, with some companies likely owing taxes despite net book income of only $500,000.

The definition of a Section 174 cost is seriously broad, which caused significant confusion and concern among taxpayers and practitioners. Current guidance bases the definition of Section 174 on the Code of Federal Regulations, which defines it as “expenditures incurred in connection with the taxpayer’s trade or business.” Which represent research and development costs in the experimental or laboratory sense. The term generally includes all such costs incident to the development or improvement of a product.

Taxpayers have options for handling changes to Section 174, including doing nothing, accepting the changes, or reevaluating R&E activities. No updates to Section 174 regulations since the Tax Cuts and Jobs Act have caused doubt and concern.

Overall, these changes to Section 174 will have a significant impact on businesses and their taxes. Businesses should consult with their tax advisors to fully understand the changes and their implications, as well as to evaluate their options for minimizing costs and optimizing their tax situation.

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