Research and Experimental (R&E) Costs – 2022 Tax Law Changes

For tax years beginning after 2021, research and experimental (R&E) costs must be capitalized and amortized over five years for tax purposes (15 years if incurred outside the United States). In prior tax years, R&E costs could be expensed or capitalized at the taxpayer’s discretion. For some companies, this may result in a significant amount of expenses that will take five years or longer to deduct and increased taxes as a result. Attempts have been made in Congress to remove the capitalization requirement retroactively, but no law changes have occurred to date. Assuming the law doesn’t change, the capitalization requirement takes effect with 2022 tax returns.

What are R&E Costs?

R&E costs are those incurred by companies intended to discover information that would eliminate uncertainty relating to development or improvement of a product, process, software, technique, formula, or invention.  They include qualified research expenses (QREs), also known as direct research and development (R&D) costs, plus incidental overhead costs relating to R&D activity, according to Internal Revenue Code (IRC) Section 174 and related regulations.

According to IRC Section 41, QREs, or direct R&D costs, include in-house research expenses in four categories:  (1) wages paid to employees performing qualified research services, (2) supplies, (3) computer rental or usage, and (4) 65% of research expenses paid to contractors.

R&E includes these QRE costs plus an allocation of overhead costs indirectly associated with (“incident to”) the R&E activities.  The requirement to capitalize an allocation of indirect costs results in R&E costs being greater than direct R&D costs.  Examples of allocable overhead include:

  • Human resources and payroll department salaries and benefits
  • Building depreciation
  • Utilities
  • Drawings, models, and lab materials
  • Attorney’s fees

Allocations of overhead costs to capitalized R&E costs are determined using applicable statistical bases, such as employee headcount, square footage, and other factors.

Can the R&D Tax Credit Still be Claimed?

Yes, the new capitalization rules for R&E costs do not change a company’s ability to claim the R&D tax credit.  The new rules do require any costs claimed for the R&D credit to be treated as R&E, which in turn requires all R&D costs to be capitalized and amortized as part of a company’s overall R&E costs.

 Takeaways and Recommendations 

  • If a company discovers that it has R&E activities, it will be important to comply with the R&E capitalization and amortization requirements. This is the case regardless of whether the company claims the R&D tax credit.
  • Businesses with R&E activities need to implement a reasonable way to identify indirect costs that are incidental to research, then allocate them for capitalization purposes using acceptable allocation factors.
  • An R&D credit study may be a good place to start evaluating the existence of R&E costs for two main reasons:
    • It will allow a company to receive an R&D credit, which may be helpful as a possible offset against the potential tax caused by capitalizing R&E costs.
    • It will help a company identify the R&D/QRE portion of the costs to be capitalized and amortized for compliance with new tax rules.
  • Congress is currently attempting to change the capitalization requirement and restore the prior tax law allowing full expensing of R&E costs retroactive to January 1, 2021.

If you have questions or concerns about R&E costs, please contact your tax advisor at Santora CPA Group for more information at (302) 737-6200.

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