Concerns raised about 2017 tax law’s impact on industry R&D

While the Tax Cuts and Jobs Act of 2017 was passed more than five years ago, many businesses seem to be just discovering the effects of one of its sections this tax season. The law stipulated that, for tax years beginning in 2022, companies could no longer choose to expense their entire “research and experimentation” costs in one year and must instead amortize those cost over five years (with a half year look-back). The result is posing a threat for companies with limited, or non-fungible, cash flow. Congress displayed broad support for restoring the original rule but failed to pass the change during the previous session. The question on many people’s minds is, “what happens now?”

Background

Prior to Dec. 31, 2021, Section 174 of the Internal Revenue Code allowed companies to choose between expensing 100% of research and experimentation costs in the current year or amortizing those costs over five years (or longer, in the case of foreign expenditures). The 2017 tax law ended this practice, requiring all companies to amortize their costs.

The Journal of Accountancy provides an example of how this change will affect a company with $100,000 in annual research expenses. In tax year 2021, that company could deduct $100,000. For 2022, that company will only be able to deduct $10,000 — a result of the 20% amortization rate, adjusted by the half-year convention. Assuming steady research expenses, the deduction increases by $20,000 per year until reaching $100,000 again for the 2027 tax year.

Section 174 costs include qualified research expenditures that count toward the federal R&D credit but go beyond the credit’s limits, covering foreign costs, software development or allocable overhead. Unlike the tax credit, Section 174’s tax benefits — and, therefore, the new rules — are relevant to companies regardless of their net profit or loss.

One challenge for dealing with the change is that limited documentation seems to exist around how companies determine what costs are required to be counted as Section 174 expenditures. This is a topic that accounting firm KBKG reports an Internal Revenue Service associate chief counsel acknowledged during a recent conference, and that Deloitte and others have mentioned in their discussions of the issue.

In December 2022, the IRS published some guidance related to implementing the rule, which may require companies to report a change in accounting method. Additional guidance that better-defines Section 174 expenses may be forthcoming.

Impact

The long-run tax impact for companies with steady research expenses is minimal, as illustrated in the example above, with annual deductions eventually returning to their original values.

However, the short-term costs of the shift to amortization could be quite significant. The Tax Foundation has estimated that the change would generate more than $40 billion in tax revenues for 2022, and a total of $119 billion over 10 years. The Information Technology and Innovation Foundation calculates that restoring full expenses of research costs would enable the creation of 81,000 direct jobs.

Of course, these estimates describe aggregate costs, and the fallout for individual companies, particularly new and young businesses, may be catastrophic. Many startups do not have cash on hand or incoming revenues to cover a significant tax bill. Further, companies that have funding from government, university or foundation research contracts or grants are likely prohibited from using these funds to cover tax bills.

Recipients of Small Business Innovation Research (SBIR) awards are among the entities concerned about their ability to pay their taxes owed for 2022. The National Institutes of Health published a reminder on March 17, 2023, that SBIR funds cannot be used to pay taxes, although companies could pay taxes from the “fee” portion of their award. However, as the fee is capped at 7% of total SBIR costs, this may be insufficient for many companies.

Actions

Over the past several weeks, some organizations that support young, research-intensive companies have become outspoken on the need for Congress to reverse course on Section 174 tax rules. These efforts include the following:

• American Institute of CPAs submitted a letter to Congress;
• Eva Garland Consulting, LLC coordinated a letter to Congress signed by hundreds of organizations and companies; and,
• Small Business Technology Council published a letter to Congress and has set up a process for companies to contact their delegations with the message.

Congress has also begun the process of formally considering a change in the new session. Sens. Maggie Hassan (D-NH) and Todd Young (R-IN), joined by 10 of their colleagues, re-introduced their bill that would restore full expensing of research expenditures (and strengthen the R&D tax credit). This bill passed the Senate with a 90-5 vote in 2022 but broader disagreements over tax law prevented the bill from becoming law.

During the previous session, the House was more focused on a proposal to extend the change to an amortization requirement by an additional four more years, than to reverse it altogether. A provision to this effect passed the House as part of the Build Back Better Act but was not included in the Inflation Reduction Act.

Small businesses hoping for a quick change in policy should be aware that in theory, Congress could act quickly, given the bipartisan and bicameral support for reversing or delaying the Section 174 amortization requirement. In practice, though, Congress tends to act quickly only when forced to do so, and there may not be a must-pass bill until the debt ceiling is reached or the end of the fiscal year; additionally, a reversal in policy would add to the deficit which could complicate passage.

NFIB says small businesses support the 2017 tax law

The National Federation of Independent Businesses (NFIB) in June 2021 surveyed their members and reported in NFIB Tax Survey 2021, “Of respondents who expressed an opinion, more than three-fourths believed the tax law had a positive impact on their business.” The NFIB observed, “The Tax Cuts and Jobs Act of 2017 (TCJA) made several significant changes to the tax code that affected small business owners, including lowering the federal income tax rates, introducing a 20% passthrough deduction for certain small business owners (Small Business Deduction), and reducing the corporate income tax rate for most C-Corp businesses.”

The survey did not ask any questions regarding Section 174.

In a 2019 press release, an NFIB official said, ““Small business optimism has continued a two-year trend of historically high levels and this report demonstrates that passage of the Tax Cuts and Jobs Act has been instrumental for the small business community… Following passage of the law, small businesses told us they planned to grow, hire, and raise wages, and this survey confirms they did exactly what they intended, giving the overall economy a boost.”