Fortunately, the TCJA left the research credit under Sec. 41 untouched. In fact, the TCJA’s reduction in the corporate tax rate from 31% to 21% effectively increased the value of the credit, while the elimination of the corporate AMT increased the likelihood of corporate taxpayers being able to utilize their credit.
Because the TCJA reduced the individual tax rate from 39.6% to only 37%, the tax benefit of a flow-through entity making the election to reduce its research credit by the top corporate tax rate to avoid an M-1 adjustment, reducing its research expenses by the amount of the research credit, is even greater than before, even after factoring in the resulting reduction of the Sec. 199A 20% pass-through deduction. While AMT was not eliminated for individual taxpayers, the higher AMT exemption amounts and phaseouts provided by the TCJA, combined with the $10,000 cap on itemized deductions for state and local taxes, significantly reduced individual taxpayers’ likelihood of being subject to AMT, thereby increasing the likelihood of individual taxpayers being able to utilize a research credit flowing through to them from an S corporation or partnership.
Despite not changing the research credit, the TCJA did make changes to the timing of tax deductions under Sec. 174 for expenditures that are classified as research and experimental (R&E) expenses. In addition, the TCJA expanded the definition of R&E expenses. Unlike most other provisions in the TCJA, these changes are, fortunately, not effective for tax years beginning after December 31, 2017. Instead, their effective date is delayed until tax years beginning after December 31, 2021. This will give taxpayers and lobbyists time to push for a further delay in the effective date of this unfavorable change—or even a complete elimination of the provisions.
For tax years beginning before January 1, 2022:
Taxpayers have the option under Sec. 1774 to either immediately expense their R&E expenditures when paid or incurred or capitalize the expenditures and amortize them over a period of no less than 60 months, beginning when the taxpayer first begins to derive benefit from the R&E expenses. Alternatively, they may elect to amortize their expenditures over 10 years under Sec. 59(e) to minimize AMT adjustments.
For tax years beginning after December 31, 2021:
The TCJA eliminates taxpayers’ ability to immediately expense their R&E expenditures when paid or incurred. Instead, they will be required to capitalize them and then amortize them ratably over a five-year period (15 years for specified foreign expenditures) using the straight-line method and a half-year convention. It appears that the election to amortize such expenditures over 10 years under Sec. 59(e) will also be eliminated.
To make matters worse, any costs that are capitalized under this new rule which are related to property that is subsequently disposed of, abandoned, or retired must continue to be amortized over the remaining amortization period; the remaining costs cannot be written off in the year of disposal. In addition, amounts a taxpayer pays or incurs in connection with the development of software are specifically required to be treated as R&E costs, requiring amortization under these new rules rather than immediate expensing under Rev. Proc. 2000-50 or as a 36-month asset.
Because of the likelihood of increased benefit and usage of the research credit, combined with the possibility of all taxpayers having to identify their research expenditures beginning in 2021 so the expenditures can be properly capitalized and amortized, taxpayers who have not previously explored their eligibility for the research credit should reconsider that decision and discuss their specific situation with an R&D tax credit specialist.