Recent changes in tax regulations have significantly impacted how businesses handle research and development (R&D) expenses, especially concerning Section 174 of the Internal Revenue Code. Under the new rules, certain R&D costs must be capitalized and amortized over a five-year period for U.S. expenses and 15 years for foreign expenses. This shift has left many businesses seeking ways to minimize the tax impact of Section 174 capitalization. Fortunately, with proper planning and effective strategies, businesses can reduce the financial burden. Here are three actionable strategies to minimize Section 174 tax impact.
1. Leverage Section 174 for Wages and Salaries
One key advantage of Section 174 is that it allows flexibility when capitalizing wages and salaries related to R&D activities. Unlike Qualified Research Expenses (QREs), which allow that employees QREs to qualify at 100% if the employees are deemed to have met the 80% rule. Section 174 has no such requirement.
Strategy:
When calculating Section 174 expenses for wages, you can simplify the process by only capitalizing 80% of the W-2 Box 1 wages for any employees who are qualified at 80% and above. This reduces the total amount that needs to be capitalized, which in turn decreases the overall amount that must be amortized over the five year period.
Example:
If an employee’s W-2 Box 1 wage is $100,000 and they participate in R&D activities at 80% as their qualifying time, your QREs for credit purpose would be $100,000. For Section 174, however, you would only capitalize $80,000 ($100,000 x 80%) as Section 174 wages. By doing this, you reduce the capitalized expenses and, consequently, the tax burden.
2. Apply the Section 174 Wage-to-Overall Wage Ratio for Other Expenses
After determining your Section 174 wages, you can minimize further tax impacts by applying the ratio of Section 174 wages to overall wages, as oppose to capitalizing 100% of those direct or indirect allowcable expeneses such as payroll taxes, benefits, and other overhead costs associated with R&D personnel.
Strategy:
Allocate only a proportionate share of indirect expenses (e.g., benefits, payroll taxes) that corresponds to the percentage of wages already allocated to Section 174. This ensures that only a minimal portion of indirect costs are subject to capitalization, lowering the total amount amortized over time.
Example:
Using the same wage example above, If total company wages are $100,000 and $80,000 is allocated as Section 174 wages, the ratio is 80% ($80,000 / $100,000). You can use this 80% ratio to allocate related costs, such as payroll taxes and employee benefits, for Section 174 capitalization. This lowers the overall capitalized amount, reducing the amortized expenses over time.
3. Use Favorable Ratios for Non-QRE Expenses
For non-QRE expenses such as general and administrative (G&A) costs or overhead expenses, it’s essential to use allocation methods that minimize Section 174 capitalization. One way to achieve this is by applying various ratios that limit the amount of non-QRE expenses subject to capitalization.
Strategy:
When allocating non-QRE expenses, such as administrative costs or office overhead, use favorable ratios that reduce the total expenses that need to be capitalized under Section 174. These ratios can be based on factors such as overall QREs compared to total book expenses or direct R&D costs compared to total operating costs.
Ratio Examples for Allocating Non-QRE Expenses:
QRE to Total Book Expense Ratio: A common method is to allocate G&A expenses using the ratio of overall Qualified Research Expenses (QREs) to total book expenses. If QRE expenses are a small percentage of total book expenses, this will result in a smaller portion of G&A costs being capitalized under Section 174. Example:
- Total QREs: $100,000
- Total book expenses: $1,000,000
- Ratio: $100,000 / $1,000,000 = 10% Using this ratio, only 10% of your G&A expenses would be capitalized. For example, if you had $50,000 in G&A expenses, only $5,000 ($50,000 x 10%) would be subject to Section 174 capitalization.
R&D Wage to Overall Wage Ratio: Another approach is to apply the ratio of Section 174 wages to total company wages. This ratio can then be used to allocate indirect expenses such as rent, utilities, or employee benefits, minimizing the amount capitalized. Example:
- Total Section 174 wages: $80,000
- Total company wages: $500,000
- Ratio: $80,000 / $500,000 = 16% Using this ratio, if you have $20,000 in indirect expenses, you would allocate 16%, or $3,200, to Section 174. This leaves the remaining portion deductible in the current period.
Direct R&D Costs to Total Operating Costs: You can also compare direct R&D costs (wages, supplies, contract research) to total operating costs. This ratio helps allocate non-QRE costs, such as administrative salaries, to Section 174 in a way that reduces the overall capitalized amount. Example:
- Direct R&D costs: $150,000
- Total operating costs: $750,000
- Ratio: $150,000 / $750,000 = 20% If you had $30,000 in non-QRE office expenses, only $6,000 ($30,000 x 20%) would be capitalized, keeping more of your costs deductible in the current period.
Conclusion
Minimizing the tax impact of Section 174 capitalization requires a strategic approach. By leveraging Section 174 rules for wages and salaries, applying favorable wage-to-expense ratios, and using optimized methods to allocate non-QRE expenses, businesses can reduce their overall capitalized amounts and increase current deductions. Properly implementing these strategies will help businesses navigate the new Section 174 rules, ensuring tax compliance while maximizing tax efficiency.
For businesses dealing with the complexities of Section 174, consulting a tax professional can provide additional guidance and help you apply these strategies effectively.
