“Stealth” corporate tax changes in 2022

The following content is reprinted with permission by the AIRA Journal; Volume 35: No. 2.

The Tax Cuts and Jobs Act (TCJA) was signed into law on Sept. 22, 2017.¹ The TCJA generally expires in 2025 and many of the “paybacks” in the TCJA take place in the later effective years of the Act.

In particular, three provisions of the TCJA will result in large “stealth” tax increases for many C corporations in the 2022 tax year. These provisions may disproportionately affect distressed C corporations.

Capitalization of Research and Development Expenditures

The Internal Revenue Code of 1954 added section 174 which provided taxpayers the option to immediately deduct Research & Development (R&D) expenditures under section 174(a) or elect under section 174(b) to capitalize them over a period of at least 60 months.²

For taxable years ending on or after Dec. 31, 2000, software development costs could be (i) deducted currently under rules similar to section 174(a); (ii) capitalized and amortized over 60 months from the date of completion of the project; or (iii) capitalized and amortized over 36 months from the date the software is placed in service.³

The TCJA amended section 174(a) to eliminate the ability to currently deduct R&D expenditures in tax years beginning after Dec. 31, 2021.⁴ As such, domestic R&D expenditures will have to be amortized over 5 years and 15 years for expenditures incurred outside of the United States, both with a midyear convention.

When considering the timing implication of this provision, taxpayers with R&D expenditures would be disproportionately affected in the 2022 tax year, as only 10% of the R&D expenditures could be deducted (12/60 months times 50% midyear convention). As depicted in the table below, by 2025, significantly more R&D expenditures incurred during tax years 2022 through 2025 could be deducted than during the initial 2022 tax year:

The Build Back Better Act⁵ as passed by the House of Representatives contains language to extend the immediate deductibility of R&D expenditures through the end of 2025. In addition, several stand-alone bills have been introduced to extend the deductibility of R&D expenditures. These bills have broad bipartisan support but have not yet moved past the stage of proposed legislation.

For example, in a letter to Congress, RSM US LLP wrote:

It is our belief that this new requirement . . . (to capitalize) creates a disincentive to engage in research and, as such, would significantly reduce U.S. competitiveness.

At a time when Congress is close to agreement on bipartisan legislation that will boost U.S. competitiveness in manufacturing, technology, and other areas crucial to our economic success, it is distressing that U.S. companies engaging in these efforts through research and experimentation would be made less competitive globally through the U.S. tax code. Rather than focusing time on conducting innovation and research, U.S. companies are instead trying to determine the impact of the new law on current operations, as well as associated compliance related obligations. This is clearly not consistent with the intent of the provision when it was enacted in 1954 and runs counter to the overall notion of further incentivizing the U.S. research and development environment.⁶

Section 163(j) restrictions

The TCJA attempted to address the issue of excessive corporate debt by modifying section 163(j). These changes brought section 163(j) more in line with OECD guidance and expanded the application of the limitation to all interest expense, not simply related party interest. Under the TCJA, interest expense deductions are generally limited to the sum of business interest plus 30% of adjusted taxable income (ATI).⁷ Any interest disallowed under this section is allowed to be carried forward indefinitely until it can be deducted.⁸

Section 163(j)(c) exempts small businesses from the section 163(j) limitation. For the 2022 tax year, a small business for this purpose is defined as a company with gross receipts not exceeding $27 million.

Section 2306 of the CARES Act⁹ added section 163(j)(10) to increase the ATI limitation from 30% to 50% for taxable years beginning in 2019 and 2020 unless a taxpayer elects out of the change.  

For the 2021 tax year, the ATI limitation thus decreased back to the 30% statutory amount. For tax years before 2022, ATI was computed before interest deductions, NOLs, and non-business income (essentially EBIDTA). For the 2022 tax year, ATI is computed before interest deductions, NOLs, non-business income, depreciation, amortization, and depletion (essentially EBIT).¹⁰

For example, assume taxable income is $100, interest incurred is $60 and depreciation is $50 both in 2021 and 2022. ATI for 2021 would thus be $100 plus $60 of interest incurred and $50 of depreciation = $210. 30% of $210 would be $63. As such, all interest incurred would be deductible. In 2022, ATI would thus be $100 + $60 = $160. 30% of $120 would be $48. As such, $12 of interest would not be deductible in 2022 and would be carried forward to subsequent years.¹¹ See schedule below:

As more fully articulated in a prior AIRA Journal article, “New Tax Law May Limit Interest Deductions for Distressed Businesses,”¹² distressed businesses experience disproportionately higher taxes with correspondingly lower cash flows as a result of the section 163(j) adjusted taxable income limitation. The reversion to the 30% limitation, the decrease from EBITDA to EBIT, and increasing interest rates will result in an especially difficult burden for distressed C corporations.

80% Limitation for post-2017 NOLs

The TCJA removed the ability to carryback net operating losses (NOLs) to prior tax years. However, the TCJA did extend the prior carryforward period from 20 years to an indefinite carryforward period.¹³ The TCJA also generally imposes an 80% limitation on the use of NOL carryforwards for NOLs generated in tax years beginning after Dec. 31, 2020.¹⁴

For example, assume a company is formed in 2021 and generates an NOL of ($100) in that year. In 2022, taxable income is $100; only ($80) of NOL carryforwards could be used in that year. The remaining ($20) NOL carryforward could then be carried forward indefinitely, but the taxpayer would be subject to tax on the remaining $20 of income.

Alternatively, assume a corporation was formed in 2017. In 2022, the company has $200 of income and has NOL carryforward of ($20) from 2017 and ($180) from 2021. In this example, there are no section 199A or section 250 deductions.  Section 172(a)(2) provides that the NOL deduction equals the 2017 NOL¹⁵ plus the lesser of the 2021 NOL¹⁶ ($180) or 80% of taxable income (before any 199A or 250 deductions) less pre-TCJA NOLs deducted. In that case:

• Taxable income was $200 and the pre-TCJA NOLs deducted were $20 = $180.
• 80% of $180 = $144.

As such, $20 of the pre-TCJA NOL can be deducted and $144 of post-TCJA NOLs can be deducted.  This would result in a carryforward of $44 of the 2021 (post-TCJA) NOLs to the following taxable year.

• Note if taxable income was $400 – all of the NOLs could be deducted.
  • Taxable income of $400 less $20 pre-TCJA NOLs = $380.
  • 80% of $380 = $304.  As $304 is > $180 – all post-TCJA NOLs could be deducted (in addition to all pre-TCJA NOLs).

Summary

For many corporations, the amortization of 2022 R&D expenditures over five years, combined with the 30% of EBIT deduction for business interest, will result in large increases to taxable income.¹⁷ Moreover, for companies attempting to use post-2017 NOLs, such NOL utilization will be subject to the 80% taxable income limitation.

Absent Congressional action, the amortization of R&D expenditures will have an outsized effect on 2022 taxable income. For distressed corporations with large R&D and business interest expenses, these tax law changes will be felt most keenly.¹⁸

Distressed companies may find themselves struggling to service debt payments as federal income tax liabilities increase negative cash flows.

1. ^{Public Law No: 115-97.}
2. ^{Beginning with the month in which the taxpayer first realizes benefits from such expenditures.}
3. ^{Notice 2000-50.}
4. ^{Including software development costs.}
5. ^{H.R.5376 - Build Back Better Act, 117th Congress (2021-2022).}
6. ^{Comments on research and experimental expenditures, RSM US LLP, March 2, 2022.} 
7. ^{Floor financing interest is also included in the formula for auto dealerships. IRC section 163(j)(1).}
8. ^{IRC section 163(j)(2).}
9. ^{Coronavirus Aid, Relief, and Economic Security Act, Public Law 116-136, 134 Stat. 281.}
10. ^{IRC section 163(j)(8)(A).}
11. ^{IRC section 382(d)(3) provides that section 163(j) carryforwards are treated as pre-change losses for purposes of section 382.}
12. ^{New Tax Law May Limit Interest Deductions for Distressed Businesses, Loretta Cross and Jaime Peebles. AIRA Journal Vol. 31 No. 4-2018.}
13. ^{IRC section 172(b)(1)(A)(ii)(I) — in the case of a net operating loss arising in a taxable year beginning before January 1, 2018, to each of the 20 taxable years following the taxable year of the loss; IRC section 172(b)(1)(A)(ii)(II) — in the case of a net operating loss arising in a taxable year beginning after December 31, 2017, to each taxable year following the taxable year of the loss.}
14. ^{IRC section 172(b)(2). This restriction was waived by the CARES Act for tax years beginning before January 1, 2021, and after December 31, 2017.}
15. ^{i.e., pre-2018 NOL.}
16. ^{i.e., post-2017 NOL.}
17. ^{In some cases, converting a current year loss into positive taxable income after these two large adjustments.}
18. ^{A situation is exacerbated if there are limited pre-2018 NOLs available to offset 2022 taxable income.}