Companies looking to make tax deductions on research and development on their 2022 returns may have to take smaller deductions because of new tax rules. Passed as part of the 2017 Tax Cuts and Jobs Act that went into effect in 2022, R&D expenses must be amortized over five years for domestic costs and 15 years for international costs.
This new rule goes against 70 years of previous tax law. Because of inflation, rising interest rates, and predictions of a recession in the latter half of 2023, nearly 180 CFOs signed a letter to Congress on Nov. 4, 2022, stating they expect “grave harm” to come from this new tax provision, according to the Wall Street Journal.
A total of 178 CFOs signed the letter, including ones from AT&T, Netflix, Dell, Kimberly-Clark, and Cisco.
Why are these deductions such a big deal? We explain.
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How Companies Could Deduct R&D Expenses in the Past
The U.S. Tax Code has allowed companies, starting in 1954, to expense research and development on their federal tax returns in the year they make the expenses. For example, if a manufacturer invested in research for improved robots along an assembly line totaling $150,000 in 2002, that entire amount would be deducted from their taxable income when they filed their 2002 returns in the spring of 2003.
The R&D expenses served as an immediate tax deduction while encouraging companies to invest in their future as they saw fit. Having these tax deductions on the books also provided a financial benefit to make American firms more competitive.
Enter the 2017 Tax Cuts and Jobs Act
Starting on Jan. 1, 2022, companies had to spread their research and development expenses over five years of federal returns rather than taking the deduction all at once. Using the aforementioned example, instead of reducing tax liability by $150,000 using all of the research and development expenses incurred in 2022, companies could only write down $30,000 of that total.
The new law was designed to use fewer write-downs for R&D to compensate for cuts to the corporate tax rate from 35 percent to 21 percent. So, while companies will pay fewer corporate taxes, they can no longer reduce all their R&D spending in one year.
How would businesses compensate for spreading these expenses over a five-year period? They would likely invest less in R&D in any given year.
Research & Development Is Vital to Company Growth and American Competitiveness
The CFOs believe less money will be spent on research and development because they are less incentivized to do so. The long-term effects are that U.S. companies would be less competitive with foreign companies. This news comes at an interesting time as the federal government attempts to incentivize making semiconductor chips in the United States, installing more EV charging stations, and increasing solar panel production in America.
Military contractors such as Raytheon are making higher estimated tax payments than normal. Huntington Ingalls Industries says it would see a reduction of $250 million in cash flow through 2024.
Meanwhile, countries like China, the United Kingdom, and Greece get more than a 100 percent deduction on research and development spending.
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How much will this affect companies that invest in research and development?
Ernst & Young released a report in 2019 that predicted companies would lower R&D spending by $4.1 billion every year for the first five years of this new law. The next five years may see a reduction of $10.1 billion a year.
Job cuts may also happen. EY’s report predicts a loss of 23,400 jobs yearly for the first five years and then 58,600 jobs during the second five-year period.
Cuts in spending mean fewer jobs, a delay in ROI in R&D spending, and the U.S. government could lose even more income tax revenue from job cuts.
What items could be affected by these tax law changes?
Many different items may face scrutiny in the next decade due to the way the IRS will handle these deductions.
- Software improvements that make machinery run more efficiently or staff work more effectively.
- New equipment to make industrial processes better.
- Improved product development.
- Higher levels of technology spurring further development.
- Investments in research performed at universities to make products more commercially available. As bigger companies invest in new tech, the less expensive these advancements become over time as they get more popular with consumers and businesses following widespread adoption.
- Fewer patent applications.
What does my company need to do?
If you haven’t made estimated payments to the IRS for taxes yet, you might consider doing so before you file your taxes. You should also develop a plan for what to do with your research and development investments. Will your R&D deduction, or a lack thereof, counteract the lower corporate tax rate? Are you thinking about reducing your labor costs or replacing some people with investments in technology?
Companies cannot rely on Congress to act following the mid-term elections as this session winds down. Businesses will need to come up with relevant plans to handle investment in R&D as well as inflation and a possible economic downturn in 2023.
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Who can help my company plan for the future?
Your corporate income taxes may go down this year, but it could be offset by a smaller deduction for research and development expenses.
Hiring and retaining a tax professional and business advisor can help you plan for the future when tax laws, like the R&D deduction, change. Having a partner on your side, like the team at The Whitlock Co., can provide relevant, high-level business advice for your company to optimize your profit, revenue, and tax liability.
Every business situation is unique, which is why your company needs someone who can perform a deep dive and analysis into your company’s model to help show you a way forward through potentially rough seas ahead.
Contact us or call (417) 881-0145 for more information.
