Sec. 174 Amortization Update

August 11, 2023

With Legislation Building Support, What Should Taxpayers Do NOW?

Introduction

Everyone’s asking — Will mandatory Sec. 174 amortization be repealed?  Business owners, the scientific community, and tax professionals all hope the answer is yes, but there is still a way to go. Three different bills are making waves in Congress — and bipartisan support is encouraging — but for the moment, the amortization requirement remains in effect.  

As we continue to watch Congress for updates, taxpayers must seek expert guidance who can advise them of their options during this waiting game.  

The Situation: Mandatory Amortization of Sec. 174  

Before the Tax Cuts and Jobs Act (TCJA) of 2018 was passed, taxpayers could choose to immediately deduct their Section 174 Expenses or to capitalize and amortize them over a period of 5 years.

The TCJA contained a provision mandating that – beginning in Tax Year 2022 – Section 174 expenses must be amortized over 5 years or 15 years. Section 174 Expenses may no longer be immediately deducted.  

By amortizing the deduction over 5 years, taxpayers will see a higher net taxable income initially. Generally, taxpayers will pay more taxes in year 1 and year 2, but not more overall. In fact, most taxpayers will “break even” by year 3 and pay little to no tax in that year and beyond. Smaller firms and start-ups will likely feel the impact of the increased tax liability more deeply, even if it is only short-term.

An additional source of confusion: many expenses people thought were Sec. 162 – and deductible – are actually Sec. 174 and must be amortized. The IRS will be looking out for 162/174 mismatches this year.

The amortization requirement has created a great deal of confusion relating to identifying costs and maintaining compliance. Further guidance is expected, but at this point, implementation of the requirement is proving a challenge and a burden, particularly to smaller start-ups.

The Prospective Legislation 

American Innovation and Jobs Act (S.866)

Proposed in March of 2023, the American Innovation and Jobs Act would reinstate the immediate deductibility of Sec. 174 expenses. However, it also includes clauses that would significantly expand the R&D Tax Credit:

  • Doubling the cap for the refundable portion of the R&D payroll tax credit from $250,000 to $500,000, ultimately raising it to $750,000 in ten years
  • Expanding the credit rate for start-ups from 14% to 20%
  • Expanding eligibility for the payroll tax credit by increasing the gross receipts threshold to $15M from $5M
  • Increasing the period startups can claim the refundable credit from 5 years to 8 years

The Act has received overwhelming support from both Democrats and Republicans, and has 37 of the 51 Senate cosponsors needed to pass.

American Innovation and R&D Competitiveness Act of 2023 H.R. 2673 

The bipartisan American Innovation and R&D Competitiveness Act was reintroduced in the House on April 18. Currently, the Bill has 137 of the 218 votes required.
The Bill includes language that would revert Section 174 to the deduction and capitalization options in effect prior to the TCJA as well as conforming amendments to Sections 41 and 280C, which would allow for current-year expensing of Section 174 expenses.

“The Build It in America Act” (H.R. 3938) 

The most recent piece of relevant legislation is the Build It in America Act, proposed June 9, 2023 in the House. It currently has no cosponsors.

The Act would repeal the mandatory amortization established by the TCJA, and the repeal would be retroactive, allowing expensing for tax years beginning after December 31, 2021, and before January 1, 2026. However, as drafted, the Section 174 expensing availability would expire again at the end of December 31, 2025.

Complexity in the House and Senate means that these exciting pieces of legislation may not pass as written any time soon, leaving taxpayers stuck in a strange sort of purgatory.

The Options: What Should Taxpayers Be Doing About Sec. 174 NOW? 

Taxpayers impacted should absolutely consider waiting until 9/15, 10/15, or their extended fiscal year filing deadline in hopes of a retroactive repeal for TY 2022, or the issuance of much needed guidance by the IRS and Treasury should Congress fail to act. 

Some practical recommendations: 

  1. Determine whether the taxpayer has a compliance risk in filing for 174 amortizable expenses:
    • Does the Taxpayer have any custom design, development, technology integration, or other advancements?
    • Has the Taxpayer claimed the R&D Tax Credit in the past?
  1. If so, mandatory amortization applies, and the following steps must be taken: 
    • Develop a methodology to calculate 174 expenses.
    • Carefully review expenses to determine the proper classification between Section 174 and Section 162, keeping in mind that the IRS will be looking closely for compliance.
    • Take advantage of Rev. Proc. 2023-11 in TY 2022 to avoid filing Form 3115.
    • Prepare for the need to – most likely — make additional payments.
    • Plan for the next five years, 2022 to 2027, and be prepared for higher taxable income and tax liability, especially initially. Many small businesses may experience restricted cash flow in the first several years. 
  1. Offset increased tax liability by exploring the R&D Tax Credit and looking into other available strategies. Cost Segregation or Energy-Efficiency Incentives may be helpful in certain scenarios. 
    • Whether or not 174 amortization is repealed, employing these strategies will result in the greatest overall tax benefit in the medium-to-long term (5+ years).
  1. The 199A Qualified Business Income (QBI) Deduction is another helpful option to Qualifying pass-through entity owners may deduct up to 20% of their QBI.
  2. Monitor IRS guidance and upcoming legislation and have a plan for when repeal happens – and a plan for if it doesn’t. 
  3. DO NOT skip a year of claiming the R&D Tax Credit to avoid amortizing Section 174 expenses. The R&D Credit doesn’t create Sec. 174 expenses – if you have them, you have them, and they must be amortized whether or not you claim the R&D Tax Credit. Plus, if you consistently claimed the R&D Tax Credit, and suddenly you don’t, that’s a major red flag that the IRS will notice.

Most importantly, work with taxation experts to ensure that you are in compliance while we wait for further clarity. The IRS has heightened requirements to claim the R&D Tax Credit, and documentation is more important than ever. To ensure that your Credit is fully leveraged, amply supported, and completely defensible, it’s crucial to pick a team you can trust.   

Taxpayers impacted should absolutely consider waiting until 9/15, 10/15, or their extended fiscal year filing deadline in hopes of a retroactive repeal for TY 2022, or the issuance of much needed guidance by the IRS and Treasury should Congress fail to act. 

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