Tax pros must grasp Section 174 amortization changes to assist small businesses in accessing valuable research and development tax credits. These credits promote innovation but can be underutilized due to misconceptions.

Understanding these amendments helps you identify qualifying activities, costs, and differentiates between qualified small business (QSB) income tax credits and payroll tax offsets. This knowledge will allow you to optimize tax benefits for your clients.

NATP recently partnered up with ADP to host the webinar, Tax Credit Opportunities: R&D and Section 174 Expenses. Below, you’ll find top questions from a recent webinar on the topic and their accompanying answers.

Q: Do you have to take the credit, since there is no economic benefit based on your examples?

A: Per IRC 41, there is no requirement to take the R&D tax credit. You may want to review the new rules under IRC 41 regarding the applicability of Section 174 amortization requirements.

Q: What is the difference between startup cost vs. R&D?

A: Many companies may have qualifying R&D activities at the onset of their business activities. However, per IRC 41, not all R&D cost may be considered startup cost and vice versa.

Q: How can you be approved for having the R&D credit?

A: We recommend using a professional with in-depth knowledge and expertise on the R&D tax credit to conduct a full study for the client.

Q: From what I have read, I don’t think a company that designs and installs fire water sprinklers in buildings would qualify for this credit. Would you agree or am I wrong?

A: You may be correct although it may be worth further conversation to see if they are doing anything different or innovative from a design perspective.

Q: What is considered the ‘date placed in service for amortization’ for the R&D expenses?

A: Per the statute and draft regulations, the IRS uses a midyear convention for Year 1 placed into service.

Q: The instructor said that R&D expenses are amortized for five years in the U.S. and 15 years overseas. Where can I find more specific guidance?

A: Per the Tax Cuts and Jobs Act of 2017, R&D expenses will need to be amortized over five years for U.S. expenditures and 15 years for expenditures occurring outside of the U.S. The draft regulations issued on Sept. 8, 2023, for IRC Section 41 will provide additional guidance and information.

Q: The instructor said that R&D expenses are amortized for five years in the U.S. and 15 years overseas. Can you confirm that this means research can be done in the U.S. or overseas?

A: Research may be done in any location; however, per Section 41 of the IRC, only qualifying activities within the U.S. or U.S. territories may qualify for the federal credit.

Q: Can an accounting firm have R&D credits for developing/researching which new lines of business they should go for and cost to train employees for new business areas?

A: Some accounting firms and other professional services firms have successfully qualified for R&D activities under Section 41 of the IRC.

Q: Can you share some examples of other companies besides basic tech and manufacturing that R&D would apply to? Doctor/therapists office? Consultants?

A: Generally, any business that has activities meeting the IRS four-part test under IRC Section 41 will qualify. This may include many businesses that are developing new software platforms, such as apps, and businesses that are developing new processes or supplies, such as cleaning formulas or green-friendly items.

Q: Does depreciation of related equipment classify as an R&D expense?

A: It does not qualify as a qualified research expenditure for the R&D tax credit.

Q: What is the percentage of the credit?

A: We say it is typically 6-8% of the client’s qualified research expenditures. The actual percentage can be higher for startups. The credit is actually titled “The Research & Development Tax Credit for Increasing Research Expenditures.” The calculation varies depending on how the client’s research increases or decreased based on their ‘base’ research amount.

Q: Do grants reduce research and experimental expenses that are qualified for the R&D credit?

A: Most of the time, yes, they do. They may still have expenses above and beyond the grant. If the grant language shows the clients still retain a portion of the IP and meet the requirements of client risk (risk and rights), we don’t need to carve out the grant at all.

Q: Do the costs have to be in the U.S. or foreign, or the location of the company?

A: It is research conducted on U.S. soil only.

Q: Where can the additional details be added on the amended returns?

A: This information can be found in the IRS’s chief council memorandum that was released on Oct. 15, 2021.

Q: Is R&D credit is something separate from Section 174 amortization?

A: Per the IRC, businesses may have Section 174 expenses that are not R&D expenses. Per the Tax Cuts and Jobs Act of 2017, R&D expenses must be amortized for five years starting in tax year 2022 for U.S. expenditures and 15 years for such expenditures occurring outside of the U.S. Please review the draft regulations issued on Sept. 8, 2023, on the irs.gov site for additional information.

Q: How does a credit against payroll taxes fit in here?

A: Some businesses that are newer in the life cycle may qualify as a “QSB” or qualified small business if the company has been in business for five years or less and has $5 million or less in gross receipts.

Q: Does an active partner’s share of partnership profits or guaranteed payments qualify as payroll for R&D credit? These are subject to FICA.

A: Yes, they do if that partner is engaged in the research activities, as required by the legislation. You can take their percentage of time on qualified activities on those pass-through profits.

Q: Do payroll taxes and employee benefits qualify?

A: For the R&D tax credit, they do not qualify unless they are part of the “Box 1” wage calculation.

Q: Do software/app development costs qualify for a U.S. business if their contracted vendor is in a foreign country?

A: Per IRC Section 41, the services must be performed within the U.S. to qualify.

Q: Does the 65% contract costs limitation still exist post Section 174?

A: Yes, per IRC Section 41, there is still a limitation of 65% of qualifying costs from 1099 contractors.

Q: How is the deduction calculated in the post-Section 174 table on page 11? ($1,050,000)

A: Note that the admin wages are taken at $1 million and the overseas software development is amortized over 15 years. However, in Year 1, you would only take 50% of the standard $100,000 in amortized costs, as noted in the footnote to account for the mid-point.

Q: Does the R&D credit reduce the Section 174 costs before amortization is calculated?

A: No, per IRC Section 41, along with the draft regulations issued on Sept. 8, 2023, the R&D credit does not reduce costs that are classified as Section 174 costs in the IRC.

Q: A chiropractor client we have is questioning whether they qualify for some of the research work they are doing. It’s not “tech” in nature but would be physical. Would they qualify?

A: Medical practitioners typically do not qualify.

For a more in-depth look at preparing this credit for clients, we’re offering this webinar on-demand now.

To learn more about ADP, visit its member page to learn more about these benefits:

• Preferred pricing including a 15% discount
• Revenue sharing including the R&D Tax Credit services
• Comprehensive suite of HCM solutions

ADP’s R&D Tax Credit team has decades of experience and processes over $1 billion in tax credits annually. It starts with a simple 30-minute discussion to uncover your clients’ credit potential. Email Jamie.Noriega@adp.com for more information.

For a more in-depth look at preparing this credit for clients, consider attending Helping Clients Claim the Research & Development (R&D) Credit on-demand webinar. In this webinar, we’ll go over how to calculate the credit and prepare Form 6765, Credit for Increasing Research Activities.