At a Glance
Main Takeaway
Recent changes introduced by the Tax Cuts and Jobs Act of 2017 have changed the rules regarding research and development (R&D) expenses under Internal Revenue Code (IRC) Section 174. These new rules have negatively affected automotive, technology, and manufacturing businesses, leading to a more significant tax burden that may stifle innovation.
Next Step
While Congress is not expected to address new major tax legislation within the 2023 legislative agenda, recent House and Senate hearings suggest they may address R&D expensing concerns in minor legislation. Understanding these potential shifts and your current R&D tax liability is essential for preparing for your 2023 taxes and estimated liability.
Existing Law on Research and Development Expenses
Before 2022, companies could deduct 100% of their R&D expenses from their taxable income in the year incurred, enabling organizations to reduce their tax liability, improve cash flow, and allocate necessary funds and investments for further innovation.
However, the Tax Cuts and Jobs Act (TCJA) of 2017 changed the immediate deductibility of R&D expenses under IRC Section 174 beginning January 1, 2022. According to the revised law, companies can no longer immediately deduct their R&D costs in the year incurred. Instead, they must spread the deduction of Section 174 expenses over five years, a process known as capitalization and amortization.
Impact of the 2022 TCJA Changes
The TCJA has significantly impacted business tax liability due to changes in R&D deductions. The requirement of amortizing R&D costs over a 5-year period results in delayed deductibility, making it less appealing for businesses to engage in R&D-led projects, hindering innovation.
These changes affected sectors heavily reliant on R&D, such as technology, automotive, and pharmaceutical industries. Other industries not typically associated with R&D, like agriculture and manufacturing, also experienced the impact of the shift. Many are having difficulty funding and executing R&D initiatives and are less incentivized to create expenses related to R&D.
According to the Tax Foundation, removing the 5-year amortization clause could benefit the national economy. It is estimated that it could lead to a 0.15% boost in the economy, a 0.26% increase in capital stock, the creation of over 30,600 jobs, and a reduction in the tax bill for all businesses.
How Congress Has Reacted to the Changes
On June 6, 2023, the House Small Business Subcommittee on Economic Growth, Tax, and Capital Access held a hearing to examine the impact of the changes introduced by the TCJA. Julie Masser, CFO and Vice President of Sterman Masser, Inc., spoke during the hearing and discussed how the ability to deduct 100% of their R&D costs allowed the family-owned company to keep up with the speed of innovation of larger corporations in the agricultural sector, since farming benefits greatly from economies of scale, the use of GPS and tractor technology is vital to farming operations.
House Representative Dan Meuser, a Republican from Pennsylvania’s 9th District, also spoke at the hearing arguing in favor of reinstating the 100% bonus depreciation rule to ease R&D costs for businesses. Subcommittee Ranking Member Greg Landsman, an Ohio Democrat, also expressed his support for a return to the pre-2022 rules in an official Committee statement.
The hearing highlighted the major setbacks that current R&D tax liabilities have on U.S. companies. It also showed significant bipartisan support for legislation lowering businesses’ R&D tax bill to promote innovation.
Senate Roundtable
On June 7, 2023, less than a day after the House Small Business Subcommittee hearings, the Senate Finance Committee and Senate Committee on Small Business and Entrepreneurship convened a joint roundtable on the same topic.
The event invited representatives from multiple industries to offer their viewpoints on the tax law changes. In testimony to the Senate roundtable, CEO and president of Warrant Technologies Michael Norris explained the law’s effects on a business’s tax burden.
According to Norris, a small business with a net corporate income of $2.5 million would face a 38% increase in its annual tax burden from $315,000 to $504,000. He described the $189,000 difference as a high risk for any small business.
If no 2023 tax changes are introduced, Norris argued, the law, as it currently stands, disincentives businesses from investing in R&D and meeting growth needs, potentially resulting in many small companies going out of business through attrition.
What Could Change in the Future?
Although businesses should continue to plan for the capitalization of R&D expenses for the 2023 tax year, changes to this deduction may be on the horizon. Based on broad bipartisan support for implementing pro-innovation legislation and pressure on the divided Congress to pass bills incentivizing small business growth, Congress could introduce new legislation to restore the pre-2022 rules or postpone the 5-year amortization plan in the near future.
So far, two bills have been introduced to Congress reversing the IRC Section 174 capitalization:
- On March 16, 2023, Democrat Senator Maggie Hassan and Republican Senator Todd Young introduced S.866, the American Innovation and Jobs Act (AIJA). This bipartisan bill introduces numerous R&D relief measures to ease 2023 taxes for businesses, including reversing Section 174 capitalization, effective in taxable years beginning after December 31, 2021.
- On April 18, 2023, House Representatives Ron Estes and John Larson introduced H.R.2673, the American Innovation and R&D Competitiveness Act of 2023. This bill targets the 5-year amortization clause of the TCJA. If passed, the bill would repeal this requirement and reinstate the pre-2022 deduction. This bill is a 2023 follow-up to the previous Congress’s R.1304, which was introduced in 2021 and failed to pass.
While such proposals have been introduced in the past, hearings and roundtable discussions launched by the House and the Senate suggest one of these bills could be signed into law by the end of the year.
Prepare for Your Business’s Future with Windes
As a business owner, understanding the evolving landscape of tax regulations is crucial for planning your financial strategies and minimizing your tax liability in 2023. Partnering with a business advisory firm like Windes can ensure you meet your current tax responsibilities regarding R&D expenses and plan ahead.
The tax professionals at Windes offer comprehensive business accounting services to help you navigate changes to your 2023 tax bill, including tax credits and incentives. We will help you remain informed on the latest changes in business tax legislation, estimate the impact of the most likely legislative changes, and assist you with tax planning in anticipation of potential new bills. Our professionals can help project cash-flow needs as 2023 tax changes impact your business.
Connect with us today, and let us help your business thrive.