Up to and including the 2021 tax year, the IRS allowed for the immediate expensing of qualified research expenditures (QREs) in the same year they were incurred. Many startups further took advantage of this law to calculate an R&D tax credit that could be applied against the current year tax liability, or if there was none, applied against the subsequent year’s federal payroll tax to reap a near-immediate real-dollar benefit. This was a huge benefit to many early-stage startups, especially those without revenue, and partially offset the cost of continued research.
However, an update to the R&D credit law, enacted as part of the 2017 Tax Cuts and Jobs Act, intended for a “sunsetting” of the immediate expensing option to occur for tax years beginning after 2021. Without the expensing option, startups are required to capitalize and amortize (spread out) the domestic QREs over a five-year period and foreign QREs over a 15-year period.
This has the effect of drastically reducing the amount of R&D expenses that can be deducted in the current year. Startups with revenue that previously sheltered that income with R&D expenses may now have a tax liability. Pre-revenue companies that enjoyed a large payroll tax offset may see that figure significantly lowered.
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On a positive note, the Inflation Reduction Act of 2022 approved two key improvements to the tax law for the R&D credit. It increased the amount of R&D credit that can be applied against payroll taxes to $500,000 from its previous $250,000. It also expanded the application of that payroll tax credit from just FICA taxes to now include Medicare payroll taxes.
Now that 2022 is over, it behooves startups with extensive R&D expense deductions to contact their tax professional to understand the implications of these changes against their 2022 tax return, or to possibly prepare a tax projection now to get a heads up on any potential tax due in April 2023.
On a final note, there is an effort in Congress to extend the expensing option; if that passes, we will publish an update.
This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax advice in this article. If you would like to engage with us, please contact us here.
