In recent months, concerned AEC firm leaders have inundated us with questions about changes to Internal Revenue Code (IRC) Section 174 that could slam architecture, engineering, and environmental consulting firms with onerous tax bills and create significant cash flow problems.
Under amendments to the tax code that took effect for the 2022 tax year, businesses can no longer immediately deduct their research and development (R&D) expenses but instead must capitalize and amortize specified R&D expenditures over a period between 5 and 15 years. As a result, AEC firms could face a crippling hit of potentially millions of dollars.
What Changes Were Made to Section 174 Expenses?
When it was signed into law in December 2017, the Tax Cuts and Jobs Act slashed the maximum tax rates for corporations and individuals in the most sweeping change to the U.S. tax code in 30 years. Among the measures taken to cover the ensuing revenue shortfall was an amendment to IRC Section 174 that eliminated the current-year deductibility of R&D expenses from taxable income starting in tax year 2022.
While AEC firms can still claim the R&D tax credit, costs can no longer be expensed in the year in which they occurred. Instead, taxpayers must capitalize and amortize all R&D expenditures for 5 years for activities conducted in the U.S. and for 15 years for activities conducted outside the U.S.
Section 174 expenses subject to capitalization include:
- Salaries, wages, and nontaxable benefits of employees conducting, directly supervising, or supporting research activities
- Software development
- Contract research costs
- Supplies and materials used in the research process
- Equipment depreciation
- Patent costs
- Overhead expenses related to research activities such as rent and utilities
To determine whether an R&D expense qualifies for a tax credit, the IRS uses a four-part eligibility test in its review:
- The expense is intended to benefit a business
- The expense is technological in nature and based on hard science such as engineering
- The expense is to eliminate uncertainty
- The expense is in the process of experimentation
The AEC Industry Is Bracing for the Negative Impact of Section 174
Although more than five years have passed since the passage of the Section 174 revision, there has been a lack of detailed guidance to help taxpayers comply. That has generated considerable confusion and uncertainty about how narrowly or broadly to interpret the code, but the impact on the AEC industry could be significant. According to the American Institute of Architects (AIA), “These changes will in all likelihood negatively impact architecture firms who have been taking advantage of a substantial up-front deduction for R&D costs.”
In addition to a greater tax burden, AEC firms are now faced with the requirement of tracking their IRC Section 174 R&D costs. However, many architecture, engineering, and environmental consulting firms are not in the practice of tracking R&D expenses — whether they were direct or indirect — since Section 174 previously allowed them to be deducted in the year they were incurred. That has left AEC firms scrambling to see what information can be extracted from their systems.
“If you have been taking the R&D credit, you have a basis for calculating the Section 174 adjustment,” says Mike Woeber, CEO and president of Corporate Tax Advisors, Inc., a Huntsville, Alabama-based tax advisory firm that specializes in research and development tax credits.
“It’s primarily a wage-driven credit. Are you employing people who are doing innovative things? That’s the meat. But Section 174 goes further. For example, what’s the overhead, indirect labor, payroll taxes, and retirement that you are paying that’s not included in the R&D credit computation. Start with that labor then go back into indirect costs, and you can come up with a Section 174 expense.”
Woeber continues: “Now, different expenses qualify for the credit. Under Section 174, you must bring in the indirect costs. So, if your accounting system allows for it, you could set up an R&D cost center, but that creates a bit of an accounting nightmare. Instead, look at R&D labor and develop indirect cost allocations that relate to that R&D cost — the most defendable and relatable allocations. Some engineering firms will have DOT or state government requirements to create an overhead rate for billing cost-plus contracts. That would be way too high for R&D purposes, but it’s a template you could adapt for 174 — if you are doing that overhead calculation anyway, you can adapt it for an R&D rate.”
Section 174’s Further Complications for the AEC Industry
As the AIA notes, “Changes to Section 174 requiring amortization of R&D costs apply whether or not the filer also claims an R&D tax credit.” That means AEC firms can’t avoid an accounting headache by simply not claiming the tax credit.
“Some firms will just say they don’t have any R&D expenses. But you can’t do that. You have to prove it,” says Woeber. “The public firms will comply because of SEC scrutiny around the tax provisions, but some small AE firms are taking a hard look at not taking the R&D credit because they figure they don’t have to add back any R&D expenses this year. But that’s a misread. Whether or not you take the credit, you have to account for R&D expenses. And that’s what’s getting people.
“If firms had R&D expenses in the past and suddenly they don’t report any, they are playing the audit lottery. It’s probably not a good practice, and they could face penalties. It won’t give them any protection if they are audited. The other thing to worry about is you might be digging yourself a hole if you want to take the R&D credit in the future.”
Another complication for AEC firms claiming the R&D tax credit is that, according to the AIA, the IRS continues to challenge in audits the eligibility of smaller service firms “based on their interpretation that their firms are not producing a ‘tangible product’ or engaged in ‘experimentation’ under the four-part eligibility test for what R&D activities qualify for credit.”
Not only could AEC firms face an increasing federal tax liability due to the Section 174 amendments — but higher state tax bills as well. According to Thomson Reuters, states conform to the IRC in three different ways. States such as Illinois, New York, and Pennsylvania conform to the IRC on a rolling basis, meaning they adopt changes to the federal tax code as they occur. States such as Florida, Georgia, and North Carolina conform to the federal tax code on a static basis, meaning that they have adopted the federal tax code as of a certain date and do not automatically adopt subsequent changes. A third category of states such as Colorado and Oregon will selectively adopt federal tax code changes.
Stay on Top of the Latest Section 174 News with Morrissey Goodale
While AEC industry organizations and many others sought a repeal or delay of the new Section 174 expense requirements, a politically polarized Congress has yet to pass a fix. Some AEC firms filed extensions in submitting their 2022 taxes in the hope that Congress would pass corrective legislation, but that has yet to happen.
AEC firms need to do more than hope for a retroactive change. Morrissey Goodale recommends consulting with a CPA about how the changes in Section 174 could impact your tax returns and how to plan accordingly.
To stay on top of the latest changes brought by Section 174 as well as any news impacting the AEC industry, subscribe to Morrissey Goodale’s free e-newsletters or contact us today to find out how Morrissey Goodale can help your firm.
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