The R&D Credit will undergo changes starting in 2022 due to the Tax Cuts and Job Act. How will this affect your business’s research and development? Read this article to find out.
R&D Credit: The Basics
The Research and Development Credit, R&D Credit for short, is a substantial tax incentive that works as a dollar for dollar reduction of your company’s overall tax cost as a reward for invention and innovation. The name Research and Development often gets misconstrued and misunderstood, leading business owners to believe that this credit only applies to research institutions and scientists, but fortunately, that’s not the case!
The R&D Credit benefits any business making forward, innovative strides in technology, science, software development, and an array of other areas. This stretches beyond the ultra-hard science and into software development, patents and prototypes, and experimental improvements in process or production, particularly where technology is concerned. This credit exists as a government effort to encourage business owners to take risks, where they otherwise might be put off by the costs of such experimentation.
To qualify for the R&D Credit, your company’s innovations must pass the four-part test. These four parts include:
- Elimination of Uncertainty: The project must have begun in a quest to solve a problem or answer a question. Essentially, the research project should exist to discover information that would eliminate a problem or uncertainty in the development of a product.
- Technological in Nature: The project or experiment must exist within the STEM field, or hard sciences and exist to enhance or expand current technologies.
- Permitted Purpose: To qualify, the research expenditure must exist to develop or improve a business component for the taxpayer.
- Process of Experimentation: The taxpayer undertakes a clear and documented process of experimentation in order to attempt to eliminate the uncertainty. Both failures and successes are expected and encouraged throughout this process. Even if your experiment fails, the costs associated can still qualify for the R&D Credit. Think scientific method!
What is the TCJA?
The Tax Cuts and Job Act was the largest tax reform act in decades. Thus, its effects ripple out and apply to several areas of tax law. For example, the effects that the TCJA will have on the Research and Development Credit in the coming years.
The TCJA became law in December of 2017 and tax professionals have since been preparing for its effects on the R&D Credit, which will come into play in 2022. Starting then, if your company’s research and development expenditures were incurred after December 31, 2021, you must amortize them over a spread-out period of five years. Today and in the past, these expenditures can be amortized over a period of time, but they can also be deducted outright at the end of the tax year with your other expenses.
The TCJA did not directly change R&D credit provisions, but its changes do enhance some of the benefits of the credit. Additionally, some changes to research and experimentation expenditures might affect tax liability in the near future, so it is important for business owners and tax professionals alike to be aware of these changes.
The TCJA and R&D Credit: A Breakdown of the Changes
Research and Experimental Expenditures Before
- Previously, the IRS permitted taxpayers to treat software development costs as deductible expenses, even if the software itself was not copyrighted, patented, and didn’t meet section 174 requirements.
- Previously, taxpayers could expense these expenditures in the year that they occurred.
- Another option was to capitalize and amortize the expenditures over the life of the research.
Research and Experimental Expenditures After
- Now, for tax years AFTER December 31, 2021, the law specifies that certain research and experimental expenses must be capitalized and amortized. Furthermore, those expenditures must be capitalized and amortized over a five year period, or if the activities occur outside the US, a fifteen year period. Finally, amortization would begin in the midpoint of the tax year in which the expenses were incurred.
- The law includes expenses related to software development as “specified research and experimental expenses.”
- It is important to note that once taxpayers have capitalized and amortized, and the project is abandoned, the remaining unamortized basis can’t be recovered. It must continue to be amortized for the rest of the period.
Corporate Tax Rate Before
- Currently, there is a maximum corporate tax rate of 35%.
- When applying for the R&D Credit, businesses can take the Section 280C election, which, in essence, means:
- “Taxpayers can avoid reducing the deduction for research expenses or the amount charged to a capital account by making an election under Sec. 280C(c)(3) to take a reduced research credit”
- The reduced credit is net of the highest tax rate. That means that a reduction in the corporate tax rate will indirectly affect taxpayers making an election under Section 280C.
Corporate Tax Rate After
- The maximum corporate tax rate will be reduced from 35% to 21%.
- Ultimately, while the exact numbers will vary based on the individual taxpayer, this means that the reduction in the research credit will be less under the new corporate tax rate. The net R&D credit is, therefore, increased.
Orphan Drug Credit Before
- Previously, pharmaceutical manufacturers were provided a credit of 50% of R&D expenditures connected to drugs approved by the FDA for testing.
- Now, the orphan drug credit is reduced to 25% of qualified clinical testing expenses for the tax year. It also allows taxpayers elect to reduce credit under 280C.
- This is effective for amounts paid or incurred in tax years beginning after 2017.
What Does All of this Mean to You?
Taxpayers should act now, both in planning for the coming changes to R&D Credit worthy expenditures and also in working with experts to maximize the deductions that are currently available.
We’re Here to Help!
Here at Hito, LLC, we understand that tax laws can be complicated, so we’re here to help! Our in house R&D experts would be happy to answer any questions you may have and walk you through the process of creating a custom tax plan for your business. Give us a call!