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April 10, 2023
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R&D Capitalization is here to stay; here's what you need to know!
Even though R&D Capitalization was passed into law back in 2017 as a part of Former President Donald Trump’s Tax Cuts and Jobs Act (TCJA), almost everyone expected the massive tax law change to be repealed before it ever took effect. But for the last year-plus, we’ve been preparing for the possibility — which has become a reality — that R&D Capitalization is here to stay (at least for now).
Since September, we’ve written a collection of articles explaining The What, The Why, and The How-the-Heck-Do-I-Keep-My-Tax-Bill-Low of R&D Capitalization. We’ve also spent the year building the only software solution that solves for both R&D Tax Credit Filing and R&D Capitalization. So, book a call and we can talk you through any specific strategy questions.
Without further ado, Neo.Tax presents: Your Definitive Guide to R&D Capitalization…
The TCJA changed the way that R&D expenses can be deducted by American companies. Up until this Tax Year, R&D could be deducted all at once, meaning that innovative companies who spent on R&D would appear in the red both in their books and in the eyes of the IRS. However, the new law states that R&D expenses must be amortized over 5 or 15 years (depending on if the expenses are domestic or international). Therefore, only a fraction of a company’s R&D expenses can now be deducted in a given year.
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All of a sudden, pre-revenue startups will begin to appear in the black in the eyes of the IRS — so what would have been a valuable NOL will now be a hefty tax bill. And startups are not the only ones affected: CFOs from the largest American companies have warned Congress that this change will stifle innovation. Yelp’s effective tax rate will jump 20 percent this year compared to 2019 due to R&D Capitalization!
We’ve heard from many companies who are confused by the change. They ask: if we don’t file an R&D credit, do we still have to capitalize our R&D expenses? The short answer is YES. An accountant is responsible for making sure your filing is compliant with the law. R&D Capitalization is the law (at least for now). So, not amortizing your R&D expenses is not an option. In the event of an audit, the IRS may be inclined to disallow any R&D credit and/or re-calculate the expenses claimed.
So, as of now, any expense that can be categorized as an R&D expense must be amortized over 5 or 15 years whether or not you file for the R&D credit. Therefore, companies that forgo the money they’re owed in the form of a credit will simply be burdened with an even higher tax bill this year.
The true effect of the change is that it makes it imperative for innovative companies to commit to Tax Strategy year-round to minimize the impact on their tax bill. R&D expenditures that are considered “qualified expenses” can be claimed on an R&D credit; those that are not “qualified” now must be amortized. The difference between qualified and not qualified R&D spend come Tax Day? Almost 10x.
Okay, so, clearly it’s essential to maximize “qualified” expenses and minimize “non-qualified” R&D costs. But what is the difference between the two?
IRC §41 (Section 41) defined a “qualified” expense that can be claimed via the R&D Tax Credit as any R&D expense that passes the Four-Part Test: Permitted Purpose; Elimination of Uncertainty; Process of Experimentation; Technological in Nature. You can read more about the Four-Part Test here, but basically, these are expenses directly related to the creation of new products or novel uses of existing products (that includes wages, research expenses, supplies, and even cloud computing costs).
Now, IRC §174 (Section 174) defines the way companies must deal with all R&D expenses: both “qualified” and “non-qualified”. But obviously, the larger the percentage of your R&D spend that “qualifies” for an R&D credit, the smaller the amount that you’ll need to amortize. Examples of R&D costs that are not qualified (aka do not pass The Four-Part Test) include: R&D after commercial production; research for internal use only; research funded by a grant; and most research tied to social sciences, arts, and humanities.
To be an innovative company, R&D spend is essential. So, the key now is maximizing the percentage of that spend that qualifies for an R&D credit and minimizing the spend that must be amortized over 5 or 15 years.
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As long as you’re a company doing business in the United States, you have to pay taxes in the United States. In many ways, the reason for this massive change to R&D taxes is an effort to move more research jobs and spending back into the United States.
The amortization structure is designed to punish R&D spend made outside of American borders. A quick example to explain why the 15-year amortization is so much more punitive than the 5-year amortization:
In its simplest form, a deduction can be thought of as an expense that is subtracted from taxable income. So, if you made $10M in revenue and spent $5M on R&D, deducting that amount would make your taxable income $5M ($10,000,000 minus $5,000,000). But under the new R&D capitalization rules, the amendment means the deduction must be amortized, or in simpler terms, spread over 5 or 15 years, depending if the expense is domestic or international, respectively. On top of that, Year 1 can only be amortized as half a year, so that means only one-tenth or one-thirtieth of the R&D expenses can be subtracted from the taxable income that first year.
So, if your company’s R&D occurred in the States, the equation becomes $10 mil minus $1M; if it’s done abroad, the equation becomes $10M minus $333,333.33. Eventually, over the 5 or 15 years, you will technically be able to deduct the same amount as before, but this obviously increases your tax bill in the near term by quite a bit. For the company that spent exclusively in the States — that’s a $9M taxable income; for the company that did R&D abroad, that’s $9.67M. With the 21% corporate tax rate, for Year 1 taxes, that’s an extra $140K!
This is the big question, and for now, the only responsible answer is: NOT YET.
For the last six months, there have been rumors that a deal is close, but none have come to fruition. Many CEOs, CFOs, and even accountants are keeping their fingers crossed, but, unfortunately, the Crossed Fingers Method is not IRS-compliant.
So, the safest route forward is to either file now and hope the law is repealed and companies are retroactively made whole for their 2022 or to file an extension, pay your quarterly taxes as if the law is still on the books, and then hope that your quarterly taxes are refunded if the law is eventually overturned. Either way, make sure to file an R&D credit when you file your taxes — they cannot be filed retroactively.
As anyone who has watched Washington these last five years knows: betting on compromise is a longshot wager. So, plan as if the law on the books is the law of the land, and get your books in order. And, remember: we’re here to help! So, book a call today.
If you’re a company involved in software, manufacturing, architecture, engineering, food, or construction, it’s very likely that you qualify for an R&D credit. It’s just as likely that you have expenditures that can be considered R&D spend.
Two things to remember…
Neo.Tax is the only software solution that solves for both R&D Capitalization and for R&D credit filing. Let us help you navigate this massive change. We’ve been deep in the weeds on this for 12 months; we’d love to walk you through the best way to maximize your credit and minimize the impact of capitalization!
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In July, the government moved for a summary judgment ruling that Kyocera AVX, the multinational ceramics and electronics manufacturer, is not entitled to the $1.3 million amended Section 41 R&D Credit they recently claimed. The company had hired PricewaterhouseCoopers (PwC) to make the filing, and the accounting firm did interviews with subject matter experts to compute the eligible amount of Section 41 credits they could claim for the tax years 2017-2020. PwC found $1.3 million worth of unclaimed credits, which they filed in the amended Section 41 study. But, ultimately, the IRS claims that the R&D Study and documentation provided were not sufficient to support the claim, and when the IRS requested additional documentation to support the claim neither Kyocera nor PwC could produce it.
Two of the government’s objections in its case against Kyocera are especially relevant to any company that files for an R&D tax credit: 1) “The PwC study exclusively relied on interviews to determine employees' time spent on projects; it did not use documentation” and 2) “Kyocera does not have a centralized system for tracking employee time, and generally does not track employee time on projects.”
The IRS has been emphasizing the necessity of contemporaneous documentation for decades, as far back as Eustace v. Commissioner in 2002. But this recent motion for summary judgment against Kyocera could mark a potential shift towards a stricter application of their long-standing policy.
The direction seems clear—reliance on after-the-fact interviews without supporting documents is increasingly untenable.
Kyocera's reliance on a PwC-conducted study, which was ultimately deemed insufficient by the IRS due to lack of proper documentation and over-reliance on estimates, highlights a systemic risk in the current practices of R&D credit calculation.
The IRS mandates strict substantiation requirements for claiming R&D tax credits under Section 41 of the IRC. Specifically, Treasury Regulation § 1.41-4(d) emphasizes the necessity for contemporaneous documentation to support the expenditures claimed. This documentation must detail the nature of the qualifying activities and their direct connection to the claimed credits—a challenging task for businesses relying on traditional methods, particularly for those that do not have employee time tracking systems in use.
In the case of Kyocera, the IRS disputed the R&D tax credit claims due to inadequate substantiation of the research activities claimed under Section 41. The agency focused on the lack of contemporaneous documentation, relying instead on retrospective estimates from interviews conducted by PwC long after the fact. This method was seen as inadequate in the eyes of the court; they demanded a more rigorous substantiation to prove that the activities qualified as R&D.
This is where Neo.Tax separates itself in the R&D tax space. Unlike traditional methods that often rely on after-the-fact recollections and manual calculations, Neo.Tax leverages advanced AI to analyze real-time data from integrated systems such as Jira and GitHub. This not only ensures greater accuracy but also provides a contemporaneous, auditable trail of documentation that meets IRS requirements. Better yet, our AI not only reviews these systems to identify the research activities, but also uses the meta data to help allocate the time. And because the meta-data is recorded "at the same time" as the tickets in Jira, it is — by definition — "contemporaneous documentation."
By accessing data from systems such as Jira and GitHub at the time of tax preparation, Neo.Tax’s platform can automatically extract, classify, and substantiate qualifying R&D activities. This method aligns with the IRS's emphasis on contemporaneous records. The agency prefers these types of records because they are more reliable than documentation created far after when the activity occurs — certainly, an engineer creating a timesheet of his work at the end of the month is likely more accurate than asking them to recollect their work on a project completed a year, or multiple years, in the past.
Unlike traditional R&D studies conducted by large accounting firms, which rely on retrospective interviews and questionnaires, Neo.Tax’s solution utilizes real-time data to support R&D credit claims. This direct link to project-specific activities minimizes reliance on employee recollection and significantly enhances the accuracy and defensibility of claims during IRS audits.
We often speak of the way our AI solution saves time for controllers, heads of tax, and engineers by eliminating the need for time-consuming retrospective interviews. But the Kyocera case highlights another, far more stark and costly risk of relying on memory and estimations for look-back claims. The IRS is making it clear that they’re emphasizing the need for contemporaneous data. Companies who rely on the R&D credit should take note.
As businesses increasingly adopt project-management tools that capture their developmental activities in real-time, a new approach to R&D tax credit documentation is possible. Neo.Tax’s AI-powered platform provides a reliable, efficient, and IRS-compliant method to claim R&D tax credits. By leveraging data directly from the systems so-often used by innovative companies, Neo.Tax ensures that your spending on R&D is rigorously documented in accordance with current tax laws.
We can get you the money you’re owed. Just as importantly, we can deliver the data-rich study that the IRS prefers and expects.
Given the importance of extending runway in today’s high-interest-rate reality, it’s shocking to learn that just 3 out of every ten companies that qualify for the R&D Tax Credit claim the money they’re owed. In 2011, “the largest 0.13 percent of all firms in the US claimed 14 percent of the credits,” according to research by the Mercatus Center at George Mason University. So, if you’re on the fence about claiming the credit, remember that the big guys are claiming it; shouldn’t you, too?
But this isn’t an article designed to make you feel foolish. FOMO Marketing is not our thing. We at Neo.Tax have built our AI-powered R&D Credit filing tool to make sure every innovative American business can claim the money they’re owed. So, get in touch with our team of experts to walk you through the process! And if you didn’t file for your credit last year (or the year before that, or the year before that…), don’t worry. We can help with that, too!
Many people don’t know this, but you can claim the R&D tax credit for the current tax year plus amend returns for the previous three tax years. For example, in 2023, you could claim credits for 2023, 2022, 2021, and 2020. That retroactive tax filing could be worth hundreds of thousands of dollars (or more) for your company. Neo.Tax doesn’t just stop at your prior three years, though. Due to the mechanics of the credit calculation, it may be beneficial to go back even further to substantiate qualified research activities to maximize the credit in your amended tax years. We can help with that – the lapsing of time is not a limiting factor to our technology! We know that’s getting very inside baseball; again, book a call, and we can talk you through it…
But even those who do know about the value of a Multi-Year Lookback R&D Credit often decide against filing because of the expenditure of time and effort to correctly calibrate the amount you’re owed. The big change with Neo.Tax is that by linking with your existing project-management system, our AI-powered tool can seamlessly identify qualified expenses from past years. What used to be difficult (or impossible, if enough engineers had moved on and are unreachable for interviews) is now quick, low-lift, and much more accurate than human memory could muster.
With Neo.Tax, it’s simple: if your company has a project management system that goes back x number of years, just plug it into Neo.Tax, and our groundbreaking tool can generate the projects and assign the effort for employees across each of those years. In solving for the pain of filing an R&D credit, we also built a tool to make Multi-Year Lookbacks painless and worth it for every innovative company.
The big guys have been claiming it for years. Now’s the time to claim it too.
