Section 174—Having Fun Yet?
We’ve been getting buried with inquiries from concerned AE firm leaders about Section 174, the rules of which require businesses to capitalize and amortize specified R&D expenditures over a period of five years.
To dig into some of the details, I spoke with 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. Here’s how it went:
Mike, thanks for talking with Word on the Street about this issue. It’s worrying many folks in the AE industry.
I can see why. It’s real money, and these are unchartered waters.
For starters, can you give an overview of Section 174?
Sure. The Tax Cuts and Jobs Act (TCJA), passed in December 2017, created a lot of advantages for taxpayers, including a reduction in the maximum corporate tax rate to 21%. While the tax savings were significant, it had to be paid for somehow. So, to get the plan through the Congressional Budget Office, Section 174 was amended to eliminate current-year deductibility of R&D costs beginning in 2022. Taxpayers must now charge those expenses to a capital account that would be amortized over five years.
This has to be a shock to the system.
Very much so. In the last four years, there have been a lot of efforts to overturn the revision, but things got increasingly contentious in Congress. We used to have a tax bill every other year, but we haven’t had one since 2019. There were other issues that needed addressing like COVID and climate change, and tax issues were largely ignored. It’s been five years since the TCJA passed, and now it’s on our doorstep and we have to deal with it on tax day.
How have firms been tracking R&D expenses?
In the past, the law said if you had an R&D expense—it didn’t matter what it was, whether it was a direct or indirect expense—it would be considered deductible. Because of that, most businesses didn’t account for R&D costs at all—they didn’t classify them as R&D. They just lumped everything in together because it was deductible anyway. It’s been the practice for the last 20 years, and suddenly you can’t deduct a block of expenses. Now it’s a scramble for firms to see what kind of information can be extracted from their systems.
Can firms still take the R&D credit?
Yes. The credit rules have not changed. Firms can still claim the credit they always have. It’s just the expenses that are not fully deductible in one year. So, the credit is still calculated the same way. The problem is that some firms will just say they don’t have any R&D expenses. But you can’t do that. You have to prove it. 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.
That sounds like a risky strategy.
It is. If firms had R&D expenses in the past and suddenly they don’t report any this year, 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.
In addition to a higher tax burden, AE firms are now faced with the requirement of tracking their IRC Section 174 R&D costs. As you mentioned, many firms are not in the practice of tracking research costs since Section 174 previously allowed them to deduct R&D expenses in the year they were incurred. So now what?
If you have been taking the R&D credit, you have a basis for calculating the Section 174 adjustment. 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. 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.
What are the chances this revision to Section 174 can be reversed, and do you think a reversal would be retroactive?
There is bipartisan support to have it done away with. But while the bill has been introduced, it has to get attached to a piece of legislation that actually has a chance of passing. Will it be retroactive? We’ll have to wait and see. The bill that came out a couple of weeks ago made it retroactive to January 1, 2022, which means it would completely disappear. The desire is to make it retroactive. Will it happen? We don’t know. But the proposals are to make it happen, and that’s encouraging. Some firms have decided to file extensions in the hope Congress will come to the rescue by mid- to late summer. It’s not a bad idea since there is so much focus on it right now. I still feel like it will get resolved, but in the meantime, firms are facing a hit of potentially millions of dollars, and that can be crippling.