While we wait for a Section 174 fix, software companies may feel the largest impacts
Taxpayers and practitioners had hoped that a “fix” under Section 174 would have been addressed by Congress already. With the first quarter of 2022 behind us, however, we still have no legislation in place that would defer or eliminate the amortization requirement that went into effect for tax years beginning after December 31, 2021. This means taxpayers must now account for the new rules for federal and state estimated tax purposes as well as financial statement reporting. Hope is certainly not lost though that Congress will act on Section 174, and many believe it’s a matter of when rather than if Congress will pass a legislative fix.
Capitalization requirement now in effect
Historically, Section 174 of the Internal Revenue Code allowed taxpayers to currently deduct research and experimental (R&E) expenditures in the year incurred, although elections to amortize the costs over 5 or 10 years were also available. Companies large and small that engage in research-based activities have relied on full expensing as a powerful cost recovery mechanism since Section 174’s enactment in the 1950s.
The Tax Cuts and Jobs Act (TCJA) of 2017 made a significant change to Section 174 that went into effect on January 1, 2022. The law change eliminated the ability to currently deduct R&E expenditures and instead now requires these costs to be capitalized and amortized. The amortization period is 5 years for domestic expenditures and 15 years for foreign expenditures.
How are software companies impacted?
Any taxpayer investing in research and development is impacted by the law change. Software developers, however, may feel the sting more so than other organizations for two reasons.
First, Section 174 now explicitly references software development as a covered expense. This is a departure from prior law where the statute did not mention software development. Instead, Revenue Procedure 2000-50 was issued and acknowledged that the costs of developing software so closely resemble the sort of R&E costs contemplated under Section 174 that similar treatment was warranted (thus, full expensing was permissible and generally the option chosen by taxpayers). With the inclusion of software development under Section 174, these costs are now squarely subject to the capitalization mandate.
Second, the 15-year amortization period for foreign R&E costs is particularly problematic for software developers since the use of offshore developers has dramatically increased over the last decade. Making matters worse is the fact that foreign R&E costs are not eligible for the research tax credit under Section 41. As such, software developers are now in an unfortunate position where their offshore costs must be amortized over 15 years and such costs are not eligible for the valuable research credit—this double hit could give rise to significant increases in US taxable income and tax liability.
Where do things stand and what’s next?
Many commentators believe that it’s just a matter of time before the TCJA change to Section 174 is deferred or eliminated altogether, which would have retroactive effect back to January 1, 2022. Doing away with full expensing was not particularly favored to begin with and was enacted only to help pay for the tax cuts the TCJA introduced.
The Build Back Better Act (BBBA) that was passed by the House late last year called for a deferral of the change until 2026. But, with Senator Manchin’s refusal to support the bill, the legislation has fizzled in the Senate.
The Joint Committee on Taxation recently estimated that the elimination of full expensing would cost taxpayers $8 billion in additional taxes for the first quarter of 2022 alone. These figures certainly got some attention. Now there is increasing bipartisan support among lawmakers to restore full expensing.
In March, several Democratic and Republican senators submitted a letter urging Senators Schumer and McConnell to restore full R&E expensing as well as enhance the research credit for small businesses. Despite the strong support, other pressing issues (including the conflict in Ukraine, additional COVID-19 relief, and finalizing the budget) have pushed all tax matters farther down the list of Congress’ priorities.
Even though all signs may point to a restoration of full R&E expensing, the timing is uncertain, and organizations must account for the new capitalization requirement for estimated tax and financial reporting purposes until a measure is passed.
Lawmakers are considering some pieces of legislation that could include tax provisions. But, other tax proposals that are floating around Congress are much more divisive than Section 174 and could further delay a fix.
In other words, taxpayers may find themselves in a holding pattern for a bit longer…
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