Effective for tax years beginning after Dec. 31, 2021, research and experimental (also known as research and development) expenditures are not fully tax deductible in the year incurred.
Under the 2017 Tax Cuts and Jobs Act (TCJA), taxpayers who incur research and experimental (R&E) expenditures and expense these costs under generally accepted accounting principles (GAAP) are required to capitalize and amortize these expenditures.
The law states no deductions are allowed for specified R&E expenditures, now including software development. Taxpayers are required to charge such expenditures to capital accounts and amortize them over a period of five or 15 years, using
midyear convention.1 If the R&E expenditures are attributable to U.S. operations, the amortization period is five years; if the R&E expenditures are attributable to foreign operations, the amortization period is 15 years. R&E
expenditures include expenses incurred in a taxpayer’s normal trade or business that represent costs in the experimental or laboratory sense,2 as well as software development. R&E expenditures generally include all costs incidental
to the development or improvement of a product.3 Dissimilar from tax law, GAAP generally requires companies to expense R&E costs when incurred because future economic benefits from R&E expenses are considered uncertain.4
Prior to 2022, R&E expenditures could be treated as tax deductible in the year incurred. Taxpayers had the option to deduct expenditures as incurred or capitalize and amortize them over a period no less than five years. Additionally, taxpayers were
able to make an election to amortize R&E costs over a period of 10 years.5 Effective Jan. 1, 2022, though, GAAP and tax treatment became mandatorily different, giving rise to a book-to-tax difference. Taxpayers are required to add back
all R&E expenditures in the year incurred and amortize the expenditures. From an income tax perspective, the differences may result in a current federal tax liability and a federal deferred tax asset for future periods.
States don’t always follow federal rules regarding recognition of income and deductions. The states have a variety of conformity laws, with some automatically following federal law (rolling conformity), others following as of a specific date (static
conformity), and others only following specific federal laws (selective conformity).
California, a static conforming state, generally adopts the Internal Revenue Code (IRC) as it was Jan. 1, 2015.6 Since California conforms
to federal tax law prior to the changes enacted under the TCJA, taxpayers are not required to capitalize and amortize R&E expenditures in the year incurred. Thus, taxpayers may fully deduct their R&E expenditures in the year incurred.
Pennsylvania generally has rolling conformity with the IRC specific to corporate income tax, with some notable exceptions (such as net operating loss and bonus depreciation treatment). As of June 2022, Pennsylvania still conforms to the federal
treatment of R&E expenditures for corporate income tax. That said, Pennsylvania has selective conformity with the IRC for personal income tax purposes, which governs pass-through entities.7 Thus, Pennsylvania does not generally conform
to federal treatment of R&E expenditures for personal income tax. While Pennsylvania would follow federal treatment of R&E expenditures for corporate income tax, it appears that pass-through entities with R&E expenses filing in Pennsylvania
would be able to fully deduct those expenses in the year incurred.
Tennessee generally has rolling conformity with the IRC, but in March 2022 a law was enacted decoupling Tennessee from the IRC as it relates to federal treatment of
R&E expenditures under the TCJA.8 Effective for tax years beginning on or after Jan. 1, 2022, Tennessee allows taxpayers to continue to fully deduct all R&E expenditures as incurred.
Wisconsin is considered a static
conforming state, and generally adopts the IRC as of Dec. 31, 2017. This means the state conforms to TCJA with exceptions. The Wisconsin legislature passed a law that decouples from specific aspects of the TCJA, including federal treatment of R&E
expenditures.9 Similar to California, Tennessee, and pass-through entities filing in Pennsylvania, Wisconsin allows taxpayers to deduct R&E expenses as they are incurred, and doesn’t require the taxpayer to capitalize and amortize them over
the requisite period.
Although there appears to be bipartisan support to defer or eliminate this law, as of July 2022 nothing has been passed by Congress. Since financial statements must be prepared based on current law, companies filing quarterly financials have already been
impacted in 2022. Quarterly estimated income tax calculations likewise should reflect the current federal and state treatment of R&E expenditures.
Taxpayers and tax practitioners should note that any federal NOLs created
after 2017 may only reduce taxable income by 80%. In addition to federal and state tax implications and the financial reporting impact, companies should take care to maintain R&E expenditure amortization schedules for both federal and state tax
purposes. Lastly, federal and state R&D tax credits may be available to taxpayers performing qualified research and development in Pennsylvania. Pennsylvania allows taxpayers to sell their R&D tax credits for cash regardless of whether they
are considered pre-revenue or pre-profitable. Taxpayers should analyze and carefully track their R&E expenses as well as consult with their financial and tax advisers on how to navigate the effects this law will have on their business.
1 26 U.S. Code Section 174.
2 26 CFR Section 1.174-2.
3 26 U.S. Code Section 174(c)3.
4 FASB ASC 730.
5 26 U.S. Code Section 59(e).
6 California Conformity to Federal Law, State of California Franchise Tax Board. www.ftb.ca.gov/tax-pros/law/conformity.html
7 Differences Between Federal Tax Law and Pennsylvania Tax Law, Pennsylvania Department of Revenue Personal Income Tax Guide (www.revenue.pa.gov/FormsandPublications/PAPersonalIncomeTaxGuide/Pages/Pass-Through-Entities.aspx#DiffFed-PALawPrtnrship) and Amy Gill, Deputy Secretary for Tax Policy, Pennsylvania Department of Revenue, Effect of TCJA on PA (www.irs.gov/pub/irs-soi/18conpangill.pdf).
8 Franchise and Excise Tax Notice #22-03, “Research & Development Expenditures,” Tennessee Department of Revenue, May 2022. www.tn.gov/content/dam/tn/revenue/documents/notices/fae/22-03fe.pdf
9 Wisc. Stat. Section 71.22(4)(L).
John Mertz, managing director, Tom Lemon, CPA, director, and Greg Rineberg, CPA, senior vice president, all work in Stout, Risius, Ross LLC’s accounting and reporting advisory group in Philadelphia. Mertz can be reached at email@example.com, Lemon can be reached at firstname.lastname@example.org, and Rineberg can be reached at email@example.com.