2023 Marcum Year-End Tax Guide

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“Many companies underestimate their R&D tax credits or wrongly believe they do not qualify.”

Changes under recent legislation have made the R&D tax credit more beneficial but have also added complexity to the tax deductibility of R&D expenditures and documentation to support R&D credit claims. 2015 PATH ACT, EXPANDED BY THE 2022 INFLATION REDUCTION ACT The PATH Act allows the R&D income tax credit to be applied against an employer’s 6.2% portion of Social Security payroll taxes for “qualified small businesses.” A qualified small business is defined as one with less than $5 million of gross receipts for the tax year and no gross receipts for any tax year before the 5-tax-year period ending with the tax year. Gross receipts are determined under Internal Revenue Code (IRC) Sections 448(c)(3)(B), (C), and (D). As originally enacted by the PATH Act, the payroll credit is limited to $250,000 per year for up to five years, and any unused portion can be carried forward to future years. The Inflation Reduction Act has extended the benefit of the R&D tax credit to tax years beginning on or after January 1, 2023. This expansion allows for an increase in the annual payroll offset, enabling

employers to offset their 1.45% portion of Medicare tax, resulting in a total offset of 7.65%. The Inflation Reduction Act also expanded the maximum credit amount allowable to offset payroll tax from $250,000 to $500,000. 2017 TAX CUTS AND JOBS ACT (TJCA) A. R&D Expense Capitalization For tax years beginning on or after January 1, 2022, the TCJA eliminated the option to deduct R&D expenditures in the current tax year under IRC Section 174. The change in treatment requires taxpayers to charge such expenses to a capital account and be allowed to amortize R&D expenditures over five years (or 15 years for amounts attributable to foreign research) beginning with the midpoint of the taxable year in which such expenditures are paid or incurred. The TCJA also changed the formal language from “research or experimental expenditures” to “specified research or experimental expenditures (SREE)” and added the requirement that any amount paid or incurred in connection with the development of software is treated as a “specified research or experimental expenditure.” This

may restrict the ability to deduct software development expenditures for tax years beginning on or after January 1, 2022. The IRC Section 174 capitalization requirement is distinct from the R&D tax credit. While R&D credit-eligible expenditures are associated with direct costs relating to the research and development, such as wages, materials and supplies used in the conduct of research, and third party contract research amounts, the IRC Section 174 expenditures subject to capitalization is more expansive than the R&D tax credit eligible expenditures. The broader IRC Section 174 definition focuses on R&D expenditures that include direct and indirect costs, such as legal and overhead. These indirect costs are not eligible for R&D tax credit treatment. Taxpayers should note that if they are incurring expenditures that meet the definition of research and experimental expenditures, they are required to capitalize and amortize such expenditures over the applicable amortization period regardless of whether they claim the R&D tax credit. The IRS can re-classify expenditures as capitalizable under IRC Section 174, thus increasing taxable income. The R&D tax credit may help to mitigate

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