Executive summary: State section 174 conformity regardless of federal reform
The Tax Cuts and Jobs Act (TCJA) requires taxpayers to capitalize and amortize research and experimental (R&D) expenditures under section 174 for tax years beginning after Dec. 31, 2021. For taxpayers affected by the changes, state tax conformity issues will create an additional layer of complexity. With uncertainty surrounding how or whether Congress will address the section 174 capitalization rules in the 2023 legislative session, it is critical to understand existing state tax issues and potential implications of future federal legislation.
State conformity and section 174
RSM has previously discussed what taxpayers need to know about the looming required capitalization of section 174 expenditures and taxpayers should similarly prepare for state differences, regardless of whether Congress addresses section 174 for 2022.
From a state perspective, whether the state conforms to the changes made to section 174 is generally the first question to consider. Most, but not all, states have updated their conformity dates or specific conformity provisions to incorporate changes made by TCJA or otherwise conform to the provisions through rolling conformity to the IRC.
For those states that continue to maintain a conformity date for section 174 prior to the enactment of TCJA, capitalization of R&D expenditures will not be required. Current expense treatment for R&D expenditures will remain the appropriate approach for these states, requiring a federal/state modification to correctly reflect state taxable income.
At least one state, Tennessee, has enacted specific legislation to decouple from the federal capitalization requirements under section 174 and allow state-level current expensing. Other states may propose or enact legislation to decouple from the federal capitalization rules during the 2023 legislative sessions. Importantly, some states have differing conformity rules for corporations and pass-through entities, creating a disconnect between proper state treatment of expenses under section 174 for differing entity types. Pass-through entities should consider these differences, especially since conformity to section 174 is often addressed in a corporate context.
Additionally, not all states conform to section 280C, which provides that a taxpayer is required to reduce its section 174 deduction (or beginning in 2022, the amount capitalized and subsequently amortized) by the amount of section 174 expense included in its federal R&D credit computation, unless electing to claim a reduced federal credit. Many states conform fully to section 280C, but some states fully decouple, partly conform or have provided a state-specific modification to allow a subtraction for expenses disallowed at the federal level.
For taxpayers materially affected by the updated capitalization requirements under section 174 and the expense disallowance under 280C, it is imperative that conformity to the federal provisions is examined on a state-by-state basis to ensure proper treatment of R&D expenditures. State conformity to section 174 and conformity to section 280C are separate, non-correlated issues, requiring an analysis of each to determine correct state tax treatment.
The timing of federal legislation is a key factor for fixed-date or selective conformity states. With most state legislatures out of session by the beginning of summer, there is a distinct possibility that some states will not be able to respond to federal legislation timely. Changes to federal provisions effective in 2023, or earlier, may not be conformed to by many states until 2024 state sessions, or later.
With the uncertainty, and increasing unlikeliness, of an early tax bill from Congress, taxpayers should prepare for the variety of scenarios that may occur as we enter 2022 compliance season and contemplate 2023 estimates. Taxpayers with questions about state conformity to section 174 or section 280C should speak to their state and local tax advisers as well as staying flexible and prepared in the event Congress acts on tax provisions in the next couple of months.