Taxpayers are facing uncertainty around recent changes to IRC Section 174, which dictate the tax accounting treatment of research and experimentation (R&E) expenditures. Going beyond tax returns, these changes are impacting tax negotiations in business transactions.
WHAT IS SECTION 174?
The Tax Cuts and Jobs Act of 2017 (TCJA) modified taxpayers’ ability to deduct R&E expenditures for tax years beginning after Dec. 31, 2021. Prior to the TCJA, taxpayers were generally able to deduct the cost of R&E expenditures in the period they were incurred. Following the changes made by the TCJA, and beginning in tax years beginning after Dec. 31, 2021, taxpayers must now capitalize and amortize these costs. The costs are amortized over a five-year recovery period for domestic expenditures and a 15-year period for foreign expenditures. As a result, the required capitalization of R&E expenditures under the TCJA has an unfavorable impact on taxpayers engaging in R&E activities because the deduction for the costs is deferred into future tax years.
Broadly, R&E expenditures are those incurred in connection with a taxpayer’s trade or business. These expenditures represent research and development costs in the experimental or laboratory sense. The term generally includes all such costs incident to the development or improvement of a product. A product may be a pilot model, process, formula, invention, technique, patent or similar property to be held for sale, lease or license in taxpayer’s trade or business.
Amounts required to be capitalized under IRC Section 174 as R&E costs likely fall under a broader definition than costs that are includible under IRC Section 41 for the computation of the research and development (R&D) tax credit. Put another way, all costs that are includible under IRC Section 41 for the R&D tax credit are generally IRC Section 174 costs; however, not all IRC Section 174 costs are includible under IRC Section 41 for computation of the R&D tax credit. This means that the R&D tax credit is more important than ever before.
Overall, the impact of the IRC Section 174 change is unfavorable to taxpayers who are now unable to realize the deduction for R&E expenditures incurred until future tax periods.
SECTION 174 CONSIDERATIONS FOR SELLERS
The requirement to capitalize R&E expenditures will impact the character of gain and tax rate of a taxpayer selling a trade or business.
Prior to the TCJA, when R&E expenditures were deductible when incurred, a taxpayer would receive an ordinary deduction for the costs in the period incurred. These deductions would be charged to capital accounts and would reduce the taxpayer’s basis in their investment. Upon the sale of the trade or business, the taxpayer would realize gain (either capital or ordinary) to the extent that the proceeds received exceeded their tax basis in business assets.
Following the changes to IRC Section 174, the capitalized R&E expenditures are now an intangible asset on the seller’s tax basis balance sheet. Upon the sale of the business, to the extent that the sale price allocable to the R&E expenditures exceeds the tax basis, the seller may be required to recognize gain from recapture at ordinary income rates under IRC Section 1245. The changes brought forth by the TCJA mean that a seller may have an additional tax basis in assets that may be subject to recapture at ordinary income rates. This may result in a seller paying an increased effective tax rate on the sale of their business than they would have prior to the TCJA changes going into effect.
Taxpayers engaging in a sale transaction will need to be aware of the potential increase in tax resulting from the recapture of capitalized R&E expenditures. When negotiating the allocation of purchase price, taxpayers selling their trade or business will be incentivized to allocate less purchase price to the R&E expenditures to avoid recognizing gain at ordinary income rates rather than capital gains rates.
SECTION 174 CONSIDERATIONS FOR BUYERS
Buyers looking to acquire a business that engages in R&E activities may benefit from the changes to IRC Section 174 when engaging in a transaction structured as an asset acquisition.
When allocating the purchase price under the principles of IRC Section 1060 for an asset acquisition, the purchase price may be allocated to capitalized R&E expenditures through an allocation to Class V assets. When a business is acquired at a premium (i.e., the purchase price exceeds the seller’s inside tax basis), the buyer will be incentivized to allocate additional purchase price to the R&E expenditures, since the five-year recovery period for domestic R&E expenditures is a shorter recovery period than the 15-year recovery period required for acquired goodwill. By allocating purchase price to R&E expenditures, buyers can accelerate the amortization deductions to earlier tax periods and reduce their tax burden in the near term.
The provisions of IRC Section 174 that require a taxpayer to capitalize R&E expenditures are generally unfavorable to taxpayers operating businesses engaged in such activities. Taxpayers looking to sell their business should be aware of the potential increase in tax liability on the sale of their business due to the recapture of IRC Section 174 amortization deductions.
Taxpayers looking to acquire businesses engaged in R&E activity should be aware of the planning opportunities provided by IRC Section 174 to accelerate the amortization deductions from their investment and accelerate tax benefits. Due consideration and care surrounding the negotiation of the purchase price allocation will be essential in advising buyers and sellers to maximize their tax planning opportunities.
To the extent that the impact of IRC Section 174 was not contemplated at the time at which the purchase price allocation was agreed, there may be some peculiar results. It is possible that the agreed-upon purchase price allocation does not allow for an allocation to IRC Section 174 capitalization. In this case, the IRC Section 174 capitalization in the transaction year is written off, essentially allowing for all R&E expenditures to be deducted in that year. This means that certain sellers may get a benefit in the transaction year while buyers are left allocating additional amounts to 15-year goodwill rather than the five-year IRC Section 174 asset (for domestic expenditures).
To learn more about the tax planning opportunities related to the capitalization of R&E expenditures, please contact GHJ’s Transaction Advisory Services Tax Team