Protect American Jobs & Innovation
A change in the tax treatment of research and experimentation (R&E) expenses that went into effect on January 1, 2022, has significantly negative impacts on American employers. While the Tax Cuts and Jobs Act of 2017 (TCJA) essentially lowered taxes for American businesses, the bill also modified Internal Revenue Code (IRC) Section 174 regarding the treatment of R&E expenditures.
The modification requires research expenses to be capitalized and amortized over multiple years (five years for U.S.. based expenses and 15 years for foreign research expenses). As a result, many small- and medium-sized businesses face 2022 tax bills that are four times more expensive on average than in previous years. What is worse is that U.S. companies that are doing the most to keep America at the forefront of innovation are the ones getting hit the hardest by this change in tax treatment. The more significant the investment in R&E, the larger the tax hike in 2022.
While some Members of Congress are aware of the negative impacts of Sect. 174, there was a general belief this issue would “go away.” However, as the implementation date neared, Congress needed to take appropriate action to repeal this legislation, and companies are now faced with significant unplanned expenses.
Senators Hassan (D-NH) and Todd Young (R-IN) recently introduced a bill in the Senate (S.866) that would reverse the TCJA implementation of Sect. 174 allows businesses to fully deduct R&E expenses in the year they are made and expand the refundable research and development (R&D) tax credit.
Congressmen Ron Estes (R-KS) and John Larson (D-CT) have recently reintroduced the American Innovation and R&D Competitiveness Act, which will allow R&D expenses to be deductible in the year they were incurred.
Congress must act now on this legislation, enabling small- and mid-size businesses to continue investing in innovation, saving jobs, and protecting America as the world leader in innovation.
IRC Section 174 Overview and TCJA Implications
Congress passed IRC Section 174 in 1954 to allow for the immediate deduction of expenses related to research and experimental expenditures. The rationale behind this policy was clear — encourage competitive STEM applications and drive innovation within the United States.
For nearly seventy years, this policy remained unchanged – until now. Under the TCJA, U.S.-based research and experimental expenditures must now be amortized and deducted over five years; however, because of how the legislation is written, it turns into a deductible period of 6 years (given the “mid-year convention” in the legislation).
The unintended consequences of amortization are crippling small and mid-sized businesses. Every tax year through 2021, taxpayers could fully deduct all research expenses. Beginning in the tax year 2022, TCJA requires amortizing these expenses. Due to the mid-year convention, taxpayers can only deduct 10% of those expenses for the year they are incurred. As a result, the taxpayer’s ordinary business income increases, exponentially increasing overall tax liability.
This new amortization policy is not only anti-business but also acts anti-worker as these businesses will be forced to cut payroll through layoffs or close their doors. Perhaps most disappointing in this legislation is that the more research and development a US company undertakes, the more detrimental the overall impact. Thus, the unintended consequences will likely result in millions of layoffs of high-quality STEM jobs while punishing small and mid-size companies that invest in U.S. innovation.
Other News
On Friday, September 8th, the IRS released IRS Notice 2023-63, entitled “Guidance on Amortization of Specified Research or Experimental Expenditures under Section 174.”
Due to a change in the tax treatment of research and experimentation expenses, commonly referred to as Section 174, many small- and medium-sized businesses now face 2022 tax bills that are, on average, four times more expensive than previous years.
The first item of note to consider while reading the below commentary is that Notice 2023-63 specifically states that the pertinent sections of the notice “would apply for taxable years ending after September 8, 2023”. This means that for any 2022 tax year returns filed up to this point or with tax years ending after the prescribed date, the guidance included in the Notice isn’t authoritative. Although 2023-63 does state that taxpayers may feel free to use it for 2022 tax return filings. However, taxpayers must still include certain direct expenses, such as wages, supplies, contractor costs, etc. as Section 174 expenses in any current tax return filings.
The focus of Notice 2023-63 is to provide insight as to the type of costs that should be evaluated for inclusion as Section 174 expenses. This includes confirmation of certain costs that have been typically recognized as Section 174 expenses in addition to overhead costs. The overhead expenses listed in the Notice include such items as:
- “Rent, utilities, insurances, taxes, repairs and maintenance costs, security costs, and similar overhead costs with respect to facilities, equipment, and other assets used in the performance of SRE activities or in the direct support of SRE activities.”
- The Notice also includes a provision for the inclusion of “Travel costs for the performance of SRE activities or the direct support of SRE activities.”
The inclusion of these additional expenses and the allocation methods to determine the extent these costs should be included as a Section 174 expense are, in ABGi’s opinion, incredibly burdensome on the taxpayer and penal in nature.
As a result of Notice 2023-63, tax year 2022 filers are presented with a number of questions about how they should approach determining Section 174 expenses. Some of the most pertinent are as follows:
Is there a reasonable argument to exclude the overhead costs outlined in the Notice? The guidance is clear that the applicability is for tax years starting on 9/8/23 and later. It simply states that a taxpayer may choose to use the rules for tax years between 1/1/22 and 9/7/23. Because the guidance does not explicitly state that a 2022 filer must follow the rules, there is an argument that a filer with a reasonable calculation of 174 expenses will be in a defensible position.
Is there a reasonable argument that a taxpayer may calculate Section 174 expenses in various manners as long as it is considered reasonable? The Notice does provide example methodologies for determining Section 174 expenses for various categories of costs. While the Notice does not specifically state the costs must be determined using these methodologies, it does state on several occasions that whichever methodology the taxpayers utilize must be used consistently for determining Section 174 expenses in similar categories of expenses.
Current Legislation and Next Steps
Legislation has been introduced in both the House and Senate to address the issue, however, Congress has failed to act. The American Innovation and Jobs Act (S.866) was introduced in the Senate with broad bi-partisan support, led by Senators Maggie Hassan (D-NH) and Todd Young (R-IN). Companion legislation, the American Innovation and R&D Competitiveness Act (H.R.2673), was introduced in the House by Representatives Ron Estes (R-KS) and John Larson (D-CT). These bipartisan pieces of legislation would allow businesses to fully deduct R&D expenses in the year they are made, as well as expand the non-refundable R&D tax credit.
Without Congressional intervention, American companies will continue to be pummeled by high taxes and punished for innovation. By the IRS’s own guidance, a company spending approximately $1M in R&D will be forced to pay an additional $345,000 in taxes.
Related News: Current Section 174 Legislation: Restoring the Future for American Businesses
On July 11th, the Joint Committee on Taxation provided its report on the macroeconomic analysis of the Build It in America Act (H.R. 3938). Along with various other legislative items, H.R. 3938 restores a taxpayer’s ability to immediately deduct research and experimental expenditures during the year they were incurred through repealing the current Section 174 rules requiring taxpayers to amortize domestic research and experimental expenditures over a five-year period.
It comes as a surprise to no one that the committee determined that the bill would have a minimal impact on the nation’s $23 trillion Gross Domestic Product over the 10-year budget window. However, the committee estimated that all the bills included in H.R. 3938 would increase Federal revenues by approximately $157 billion over that same period.
While the scope of the report was to provide an analysis of the macroeconomic effects of the Build It in American Act should it become law, it is vitally important to be reminded of the current circumstances American businesses will continue to experience should it not pass. The new Section 174 rules are resulting in American business owners facing 2022 tax bills up to triple what they otherwise would be. As American employers are handing over upwards of 300% more of their cash to the US government, they are faced with figuring out how to cut costs to remain competitive or even just stay afloat. This very likely includes the prospect of cutting jobs or outsourcing work outside the US.
One of the main purposes of section 174 is to help foster “research or experimental expenditures”. However, the new section 174 rules are actively discouraging and effectively penalizing companies for incurring these costs because of the significant tax increase they may face as a result. Congress needs to act now and stand up for American businesses by repealing the harmful rules section 174 now includes.
On June 7th, Congresswoman Rosa DeLauro (D-CT) reintroduced the American Family Act which includes substantial legislation involving the child tax credit. This bill looks to be the official reintroduction of the expanded child tax credit legislation and serves as the legislative vehicle to negotiate the R&D tax credit provisions. While legislative details are not yet available, stay tuned for additional details as they become available.
The Senate Small Business Committee and the Senate Finance Committee held a joint roundtable to discuss tax complexity for small businesses. In this roundtable, Senator Ron Wyden specifically stated that R&D tax incentives must be paired with tax help for working families. It appears there were some candid exchanges between Republicans and Democrats about the continued negotiations on R&D and child tax credits. See the article here: Senate Roundtable.
June 7th also saw the CATO Institute publish a briefing paper that discusses how policies similar to the Section 174 amortization rules negatively impact American businesses.
In additional news, on Tuesday, June 6th, the House Small Business Committee Economic Growth, Tax, and Capital Access Subcommittee held a subcommittee hearing on the topic of American innovation and the US tax code. Subcommittee Chairman Dan Mueser’s opening statement is available here: Congressman Mueser Opening Statement. While not on the Small Business Committee, Congressman Ron Estes (original cosponsor of the American Innovation and R&D Competitiveness Act of 2023) attended the hearing to promote HR. 2673.
This article gives some additional insight into the hearing: SBC Subcommittee Hearing.
Current Section 174 Amortization Rules Prevent Help for Struggling Illinois Farmers
Struggling Illinois farmers are looking for help in coping with recent environmental changes that is putting their livelihood at stake. The long-standing R&D tax credit would normally be one viable option in the search for relief. However, the current Section 174 amortization rules actually disincentivize Illinois farmers from claiming the R&D tax credit to help recoup the costs associated with addressing this issue. The current rules would very likely result in a higher federal tax bill.
The current Section 174 amortization rules went into effect 1/1/2022. These rules require any business expenses that could be considered research or experimental costs be amortized over five years instead of being immediately deductible in the tax year they were incurred. The IRS has stated that this would be the case regardless of whether the taxpayer was claiming the R&D tax credit or not. This requirement to amortize these expenses can result in a significant increase in a taxpayer’s taxable income followed by a jump in their tax bill. All because, in the case of Illinois farmers, they incurred costs in trying to improve crop yield and crop hardiness. Farmers are already operating under extremely tight profit margins and any effort that may take away from the bottom line can seem not worth the risk. Efforts in evaluating the effectiveness of alternative tilling practices, fertilizers, soil amendments or crop rotation programs take time as well as precious farmland if test plots are utilized.
The R&D tax credit was designed to incentivize companies to continuously improve upon their existing practices and benefit from the costs incurred associated with those efforts. However, the current Section 174 amortization rules go completely contrary to that intent and can punish companies in the form of higher tax bills. Illinois farmers will be looking for ways to prevent their current struggles in the future but, under the current rules, will likely find that they cannot afford it due to the higher tax bill they will be facing due to their efforts potentially being considered as research expenses.
At ABGi, we have been fighting for American businesses and the repeal of the current Section 174 amortization rules. Lawmakers need to realize how much of a negative impact these rules have on American businesses including American farmers. Illinois Senators Richard Durbin and Tammy Duckworth must take a stand with Illinois farmers. The most readily available and effective way is for them to become a cosponsor of the American Innovation and Jobs Act of 2023 (S. 866) which seeks to repeal these harmful new rules.
