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
From 1954 through 2021, taxpayers were generally permitted to deduct R&E expenditures in full as they were paid or incurred during the tax year. As a result of TCJA, taxpayers are required to capitalize and amortize all R&E expenditures for tax years beginning after Dec. 31, 2021. The recovery periods are five years and 15 years for domestic and foreign expenditures, respectively.1
Estimated tax payments
The new R&E capitalization requirements may create higher estimated tax payment obligations for taxpayers in 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. 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 on April 15.2
To avoid penalties for underpayment of estimated taxes, taxpayers must properly calculate each payment amount. There are certain safe harbor rules for calculating payment amounts, but the rules vary based on taxpayer status.
Corporations, generally, have four options for determining and paying estimated taxes. If a corporation's installment of estimated tax is calculated under any of the following methods, no underpayment is imposed with respect to that installment. The first safe harbor method is the current year method. Under this method, the corporation is required to pay 100% of the tax shown on the return for the current tax year, or, if no return is filed, 100% of the tax due for such year.3 Each payment should be for 25% of the tax due.
The second method is the preceding-year safe harbor, which allows the taxpayer to calculate current year estimated taxes based on the tax stated on the prior-year return.4 Under this method, the taxpayer must also make quarterly payments of 25% each. To use this method, the return filed for the preceding year must show a tax liability, and the preceding year must not be a short year.
However, the preceding-year safe harbor is not available to large corporate taxpayers for determining all estimated tax payments for the current year.5 A large corporation is a corporation (or its predecessor) that had a taxable income of $1 million or more for any of the three immediately preceding tax years.6 In calculating the $1 million amount, carryovers and carrybacks of net operating losses and net capital losses are disregarded. So, in all likelihood, quite a lot of corporations that might generally be thought of as small will be deemed to be large and not be able to avail themselves of the preceding year's safe harbor. However, large corporations are permitted to calculate their first quarter estimated tax payment for the current year based on 100 percent of the preceding year's liability.7 Any reduction in the first installment caused by using the preceding year's liability must be added to the corporation's second installment.
The third safe harbor is the Annualized Income Method. Under this method, actual taxable income is annualized for a given number of months of the tax year, and a corporation will avoid penalties if it pays 100% of the tax that would be due (after subtracting allowable credits) on the basis of current income, up to a specified cut-off date, annualized for the year.8
Generally, a corporation must use one standard set of monthly periods (3-3-6-9 annualization period) unless it elects to use one of two optional sets of monthly periods to determine the annualized income installments. Corporations using annualization to reduce estimated tax payments for one or more installments must recapture the reduction in full if this method is not used to calculate a subsequent installment.
The fourth and final corporate safe harbor method is the seasonal income method. Corporations that have seasonal income are permitted to annualize their income assuming that income is earned in the current year in the same pattern as in preceding years, and estimated tax may be paid in the seasonal pattern in which income is earned. A corporation is considered to have seasonal income if, for any six consecutive months in the current tax year, the total taxable income for the same period of months in each of the three preceding tax years averaged at least 70% of total income for the preceding tax years.9 Similar to the annualization method, a corporation that uses the seasonal method to reduce estimated tax payments for one or more installments must recapture the reduction in full if this method is not used to calculate a subsequent installment.
Individuals including sole proprietors, partners, and S corporation shareholders, are usually required to make estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed. For each installment, the amount of the estimated tax payment must be 25% of the required annual payment. Generally, individuals can fulfill their required annual payments by paying the lesser of 90% of the tax shown on the return for the taxable year (or, if no return is filed, 90% of the tax for such year), or 100% of the tax shown on the return of the individual for the preceding taxable year.10
The amount of any required installment shall be 25%of the required annual payment.
Higher-income individuals are not permitted to use the 90% of the current year method. Higher-income taxpayers are individuals who had an AGI in 2021 that was more than $150,000 ($75,000 if your filing status for 2022 is married filing separately). Instead, taxpayers in this category must either pay 100% of the current year's tax, or 110% of the prior year's tax.11
The penalty for individual taxpayers is figured separately for each installment due date. An individual may owe the penalty for an earlier due date even if the individual paid enough tax later to make up the underpayment. Please note there are also other rules for calculating estimated taxes that apply to individual taxpayers with special circumstances (e.g., fishers and farmers).
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% of adjusted taxable income (ATI). Effective for tax years beginning after Dec. 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 in Congress related to eliminating the R&E capitalization requirement,12 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 closing. 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.