The Tax Cuts and Jobs Act of 2017 (TCJA) brought significant changes to the Internal Revenue Code. While the TCJA was generally viewed as increasing the value of the section 41 research and development tax credit with its modifications to section 280C(c), revisions to section 174 related to the deductibility of research and experimental (R&E) expenditures created potential pitfalls for taxpayers.
Changes to section 174
Under current law, taxpayers are generally permitted to deduct R&E expenditures as they are paid or incurred during the tax year. As a result of TCJA, taxpayers will be required to capitalize and amortize all R&E expenditures for tax years beginning after December 31, 2021. The recovery periods are five years and 15 years for domestic and foreign expenditures, respectively.1
Estimated tax payments
In general, corporations must make estimated tax payments equal to 100% of the current year tax liability or 100% of the prior year tax liability, whichever is less. Taxpayers often elect to use the prior year approach, or the safe harbor, due to its ease of application. The safe harbor, however, is not available to a large corporation, which is defined as any corporation that had taxable income of at least $1,000,000 for any of its three tax years immediately preceding the tax year involved.2 A failure to make proper estimated tax payments is subject to an addition to tax for any underpayment.
The above rules coupled with the new capitalization requirements have the potential to create higher estimated tax payment obligations for taxpayers in 2022. As noted above, large corporations – which includes quite a lot of corporations that many of us would have thought of as small -- will not be permitted to use their 2021 tax liability, a liability that was potentially reduced by the immediate deductibility of R&E expenditures, to determine their 2022 estimated tax payments, after the first installment.3 Focusing on 2022, taxpayers will not be able to deduct immediately in full R&E expenditures to reduce estimated tax payment obligations in 2022, as they have become accustomed to doing ever since 1954. As a result, taxpayers in this position may be required to make higher estimated tax payments in 2022. This is not merely a problem that taxpayers must confront in 2023 when filing their 2022 return – these estimated tax payments must be made during the course of 2022. For both individuals and corporations with a calendar year, the first of such payments will generally be due April 15.4
Will Congress act?
On February 24, 2021, H.R. 1304, the American Innovation and R&D Competitiveness Act of 2021, was introduced in the House with bipartisan support. This legislation would restore full, immediate deductibility of R&E expenditures on a permanent basis. H.R. 1304 has seen little action to date and has yet been called to the House floor for a vote. Similarly, a related bill, the American Innovation and Jobs Act, S. 749, awaits further action in the Senate. While the Biden Administration has called on Congress to invest billions in research and development as part of the American Jobs Plan, there has been only slight indication from the Administration that plans exist to eliminate the capitalization requirements established by the TCJA.
Section 163(j) interest expense deduction
And section 174 is not the only looming currently-scheduled 2022 tax increase. The TCJA re-wrote section 163(j), thus establishing a new interest expense deduction limitation. In general, section 163(j) limits a taxpayer’s interest expense deduction for a taxable year to the sum of its business interest income and 30 percent of adjusted taxable income (ATI). Effective for tax years beginning after December 31, 2021, ATI will no longer be defined in a manner&similar to earnings before interest, taxes, depreciation, and amortization (EBITDA) but will instead be defined in a manner similar to earnings before interest and taxes (EBIT). No longer being able to add back in depreciation and amortization deductions will mean that ATI will be lower, thus the section 163(j) limitation lower, and thus the amount of deductible interest lower.
While there has been some movement on Capitol Hill related to eliminating the R&E capitalization requirement, as of this writing, the capitalization requirements are still in place for 2022 and beyond. Taxpayers should not anticipate a change in the law nor should taxpayers wait until 2022 to discuss how the capitalization requirements may impact their estimated tax payment obligations, particularly considering the potentially significant impact this may have on cash flow. The window of opportunity for proper planning is beginning to close. Taxpayers should talk with their tax advisors now about the effect of these changes.
Taxpayers should also consider what impact the changes to section 163(j) may have on their interest expense deduction and on estimated tax payments. Questions related to section 163(j) can be addressed to Adam Chesman, RSM US Senior Director, at Adam.Chesman@rsmus.com.