Updated on February 2, 2024 from its original posting on January 19, 2024.
Latest Updates:
- The Tax Relief for American Families and Workers Act of 2024 has since passed the U.S. House of Representatives in a sweeping 357-70 vote
- This new bill has officially been received in the Senate as of 2/1/2024
The Tax Relief for American Families and Workers Act of 2024, has passed the U.S. House of Representatives with a vote of 357-70, highlighting the bill's wide-reaching approval. Does that mean the R&D tax credit will be fixed? Yes and no. It was never broken. In fact, it is more valuable than ever. However, some companies have been foregoing, perhaps avoiding it like the plague. Why? Because they want to avoid the financial impact of capitalizing and amortizing their R&D expenses—a consequence of the recent tax code changes Congress is now attempting to amend. Many anticipated a preemptive fix, but it never materialized.
Background
The express purpose of the updated accounting rules contained within the TCJA was to increase revenue for the treasury, or at least collect more taxes sooner, which is the exact effect it has had on companies performing significant R&D. The amended Section 174 defines R&D expenses very broadly to include all costs incident to the development or improvement of a product and went further to specifically describe software development.
In short, if you are designing or developing software, including web or mobile apps, performing any product development of any kind, or utilizing any form of science or engineering to improve your business processes or to deliver your service or produce a product, regardless of whether those efforts were successful, you have Section 174 expenses. And since the majority of Section 174 expenses are actually wages, the net result of these changes is a much less favorable tax environment for innovative companies while also reducing available jobs for skilled workers. Many have called this “the innovation tax”, which seems to be a very appropriate moniker, given its chilling effect on innovation in the United States.
Can You Avoid Section 174 by Not Claiming the R&D Credit?
Many businesses and business operators have mistakenly concluded that by foregoing the R&D tax credit, they could avoid the Section 174 amortization provisions contained in the TCJA and thus deduct all of their R&D expenses in the year they are incurred. Of course, this is not how Section 174 works, in particular under an IRS audit. It would be incredibly easy for the IRS to profile businesses that avoid capitalizing research and experimentation costs. An audit regime could simply identify businesses in R&D-rich industries and then flag any tax returns without appropriate increases to the capital account.
Will Congress Fix The R&D Tax Credit?
Given that the R&D tax credit was never broken, it cannot be fixed. But what is broken is the tax code and the way that as of tax year 2022, the amended Section 174 prohibits companies, and in particular those performing R&D, from deducting the full costs (mostly wages) as expenses, in the present year, and instead deducting them over more than five or fifteen years, depending on whether they are domestically or internationally located expenses. Virtually no other developed economy penalizes innovators this way, as it often has the effect of creating income tax liabilities regardless of whether or not a company is actually generating income, or potentially a very high effective income tax rate. This disincentivizes innovation and the creation of high-paying jobs which power our economy and its growth, keeping us economically stable, globally competitive and credit-worthy, as a nation.
Impact of Amended Section 174
For example, assume a company has $2M in revenue and $1M in R&D expenses and $1M in non-R&D expenses. In our simplistic model, this company could have up to $900K in taxable income, despite merely breaking even on a cash-basis. This company may be surprised to learn that they owe $343K in federal income tax and over $100K in state income tax. In theory, they will effectively recoup roughly one-fifth of that year’s R&D domestic expenses, each year, to be used in future years, but whether or not they will be able to utilize them depends on whether they are still in business and are producing enough revenue in future years to utilize the previously amortized R&D expenses.
The Tax Relief for American Families and Workers Act of 2024
Ok, so what’s all the hype about? This bill is steamrolling through congress with bipartisan support. If it passes, America will regain competitiveness as a center for innovation. If it passes, America will regain its former competitiveness as a center for innovation. The majority approval in the House favoring this bill gives optimism for the pending vote in the Senate. If approved, the final decision will be left to President Biden deciding the fate for H.R. 7024, and with it, the hopes of reigniting American innovation.
How Will This Bill Change R&D Expensing?
The current proposal contains these key modifications to the tax code:
- Continued immediate expensing of Domestic Section 174 Research and Experimentation expenses between tax years 2022 - 2025.
- Foreign R&E expenses must still be amortized over 15 years.
In a nutshell, this bill will partially remove the Innovation Tax, returning the tax code to how it was before 2022 and before the TCJA Section 174 amendment kicked in, but only for domestic expenses. A big win for innovators and businesses, especially small businesses.
A Temporary Fix
It is important to note that while the proposal is a positive development, it kicks the can down the road, since the TCJA made the R&D amortization requirement permanent beginning in tax year 2022. Under the new bill, the R&D Section 174 amortization requirement would be delayed until the 2026 tax year coinciding with a reduction in the Child Tax Credit. Since the passage of a tax code provision for fully deductible R&D costs is now linked to the Child Tax Credit concessions, we can be reasonably assured that a polarized Congress will have ample reason to revisit both provisions again prior to 2026.
Small businesses (under $50MM gross annual receipts) are more likely to file as pass-through entities such as S-Corps and Partnerships will be particularly impacted in 2026 as they will be taxed on phantom "profit" at individual rates that revert to pre-TCJA rates beginning in 2026. Software companies and startups that utilize overseas contractors for engineering and/or software development would still be substantially impacted by the proposal, as it does not return foreign R&D expenses to their fully deductible pre-TCJA status, and thus will likely have the effect of onshoring tech jobs.
So, Does This Fix the R&D Tax Credit?
Well, if you thought it was broken, then yes, definitely, if it passes.
A Potential Windfall For Some
Assuming it is passed, companies will be able to go back and amend their returns for 2022, taking advantage of the R&D tax credit if they previously decided to forego it (for whatever reason). This will allow them to reduce their taxes and generate refunds, as well as to better position themselves for future income tax mitigation, including for the upcoming 2023 tax year filing deadlines.
Additionally, if they complied with Section 174 and did capitalize and amortize their R&D expenses, they can unwind that expense treatment and take the full expenses in the years they were incurred, generating refunds and/or increasing their carried losses, to be used in the future to offset income. This adjustment must be spread "ratably over a two-year period," meaning it could take until tax year 2023 to fully recover the additional taxes paid in 2022. On the other hand, companies that did not comply with Section 174 in 2022 will not be subject to these amortization requirements, effectively being exempt from this aspect of the tax code.
We will continue to watch for legislative updates. In the meantime, Strike's R&D tax credit experts are here to answer your questions and provide support based on your unique business circumstances. Get expert guidance to navigate tax changes with efficiency and confidence.
Read what’s proposed for the bill here:
The technical summary: "The Tax Relief for American Families and Workers Act of 2024" (U.S. Senate Committee on Finance, 2024)
The complete bill text:"H.R.7024 - Tax Relief for American Families and Workers Act of 2024" (U.S. House of Representatives, 2024)
