The Tax Cuts and Jobs Act was passed in December 2017. While most of the tax provisions in this legislation are already effective, some provisions are just now taking effect. One of these provisions will significantly impact certain businesses starting in 2022.
Under prior law, Section 174 of the Internal Revenue Code allowed businesses to deduct research costs in the year incurred or elect to amortize those costs over a period of least five years. Effective for tax years beginning on or after January 1, 2022, new Section 174 requires businesses to clearly identify research costs, including software development costs. These costs must be capitalized and amortized over five years.
Note that research costs under Section 174 is much broader than costs which qualify for the R&D credit. Section 174 costs include direct research expenses, such as wages and supplies, as well as certain indirect research expenses, including overhead and administrative costs incident to research activities.
There are several proposals in Congress to repeal this change in the law, or to defer the effective date. Thus far, none of these proposals has been enacted into law. It is still possible that Congress could act later this year or even early next year to address this issue. There will likely be no legislative action until after the midterm elections. We will continue to monitor legislative action in the meantime.
Assuming no Congressional fix to this issue, there are actions that businesses must take. Most taxpayers have not specifically tracked Section 174 expenses, so they will need to develop a process for identifying these costs. Businesses should review their accounting procedures to determine how best to identify and track these costs. Since the capitalization of Section 174 costs could result in a substantial increase in taxable income, businesses should be prepared to pay additional federal and state income taxes. You should start planning now if this increase in taxable income will be substantial.