By: CCH AnswerConnect Editorial
https://www.wolterskluwer.com/en/expert-insights/major-changes-coming-in-2022-to-174-deduction-of-research-expenses
Major Changes Coming in 2022 to §174 Deduction of Research Expenses
A major change is coming next year to the tax deduction for research and experimental (R&E) expenditures under Code Sec. 174. For tax years beginning after 2021, R&E expenditures paid or incurred during the tax year must be amortized and deducted over a five-year period (15 years if foreign-sourced). This change made by the Tax Cuts and Jobs Act (TJCA) will eliminate the current option for taxpayers to expense such costs and deduct them immediately, including software developmental costs. Businesses will need to start planning for this change, including evaluating any upcoming R&E expenditures.
Major Changes Coming in 2022 to §174 Deduction of Research Expenses
A major change is coming next year to the tax deduction for research and experimental (R&E) expenditures under Code Sec. 174. For tax years beginning after 2021, R&E expenditures paid or incurred during the tax year must be amortized and deducted over a five-year period (15 years if foreign-sourced). This change made by the Tax Cuts and Jobs Act (TJCA) will eliminate the current option for taxpayers to expense such costs and deduct them immediately, including software developmental costs. Businesses will need to start planning for this change, including evaluating any upcoming R&E expenditures.
R&E Expenses Before 2022
Under current law, a taxpayer that pays or incurs R&E expenditures in its trade or business during the tax year may elect to:
expense them immediately and deduct in the year paid or incurred,
amortize and deduct them ratably over a period of at least 60 months beginning with the month the taxpayer first realizes benefits from the expenditures, or
amortize and deduct them ratably over a period of 10 years under Code Sec. 59(e) for alternative minimum tax (AMT) tax purposes beginning with the tax year in which the expenses are paid or incurred.
The expensing and amortization elections are intended to encourage research and experimental activities and eliminate uncertainty regarding the tax treatment of R&E costs. A taxpayer that does not make any election must capitalize R&E expenses and deduct them through depreciation or amortization.
If the research is not successful any unamortized costs may be claimed as a deduction upon the disposition, retirement, or abandonment of property associated with the expenses. This is a disadvantage of amortizing R&E expenditures and lead taxpayers to elect to expense the costs.
Software Developmental Costs
R&E expenditures for this purpose are generally research and development (R&D) costs incurred in the development or improvement of a product in the experimental or laboratory sense. Software developmental costs may be treated similarly to R&E expenditures.
Under Rev. Proc. 2000-50, software developmental costs either may be expensed immediately and deducted in the year paid or incurred, or amortized and deducted ratably over a period of at least 60 months from the date of completion of development or over 36 months from the date the software is placed in service.
The expensing or amortization treatment applies only if the taxpayer consistently treats the software development expenditures accordingly.
Expenses incurred for acquisition of software are either capitalized or amortized over 36 months beginning with the month the software is placed in service. They are also eligible for bonus depreciation. The cost of leasing or renting software for use in the taxpayer’s trade or business is deductible as an ordinary business expense.
R&E Expenses After 2021
For tax years beginning after 2021, R&E expenditures paid or incurred by the taxpayer generally must be amortized and deducted over five years if conducted in the United States (15 years if conducted outside the United States). This change eliminates the option to immediately expense R&E expenditures beginning in 2022.
This includes expensing for software developmental costs because they are specifically included in the definition of R&E expenditures under Code Sec. 174 beginning in 2022. Thus, the options provided in Rev. Proc. 2000-50 for software developmental costs are no longer available after 2021. The change, however, does not affect the options for software acquisition costs.
The new amortization rule for R&E expenditures is a departure from generally accepted accounting principal (GAAP) rules that requires most research and development costs to be expensed immediately.
Under the new rules beginning in 2022, the amortization period for R&E expenditures (including software developmental costs) begins at the midpoint of the tax year when the expenditures are paid or incurred. Amortization must continue even if the underlying property is disposed, retired, or abandoned during the amortization period.
*The option to immediately expense R&E expenditures has been an important tool for businesses for a long time. Thus, the change to require amortization beginning in 2022 will require some business to evaluate their future R&E expenditures more carefully. *