The Tax Cuts and Jobs Act (TCJA) Section 174 R&D rule change that took effect January 1, 2022 compelled some taxpayers and tax preparers to extend their income tax return filings. They held out hope that Congress would act prior to the September 15 extended filing deadline. But while the House Ways and Means Committee studied 174 and its implications, there is little evidence of common ground needed to push the legislation through before 2022 returns are due. As a result, taxpayers are now forced to commit to an understanding of Section 174 for their tax returns. Unfortunately, great confusion and consternation exists as the effect on taxable income can be significant.

Let’s look at an automation business spending $2 million per year on R&D investments. Beginning in 2022, this business cannot expense those costs under Section 174. Instead, they must be amortized over five years. The taxpayer must pay approximately $660,000 more in taxes, using the top marginal rate for pass-throughs. This, in addition to the aforementioned $2 million, means a $2.6 million expense. In 2021 a similar taxpayer investment under Section 174 would generate $2 million of immediate deductions. At a 37% individual tax rate, the 2021 tax savings is $740,000, resulting in a net cash outlay of $1.26 million—almost $1.4 million less.

This predicament—and ways to minimize its repercussions—has not gone unnoticed. In fact, the Office of the IRS Chief Counsel spoke about potential Section 174 “safe harbors” earlier this year. And while there remains uncertainty as to which R&D expenditures must be amortized under Section 174 and which do not, most agree that internal R&D investments must be recorded under 174 and thereby amortized.

While direct R&D costs may be relatively easy for the taxpayer to identify, the associated costs which are amortized under Section 174 are less clear. Let’s say our automation company occupies a building with 50,000 square feet of plant space. The company used only half of their facility then decided to use the remaining half to conduct an R&D project. The indirect costs of operating the building consisted of rent, property taxes, common area maintenance, lighting, HVAC, water usage, insurance, and other overhead costs. So, which costs must be recorded as a 174 expense?

Figuring Out 174 Costs

While Section 174 is nearly 70 years old, it is poorly understood. In determining the totality of 174 costs, Treasury regulations state that “research or experimental expenditures” generally include costs that are “incident to” the development or improvement of a product. However, Treasury regulations do not expand on this point. So, what qualifies as incident-to costs? In the context of the Financial Accounting Standards Board (FASB), incident-to refers to the relationship a cost has to specific activities. A cost is incident to an R&D activity if—and only if—the cost arises from the activity.

In our automation company example, the utilities, water, electric, and gas arguably constitute Section 174 costs to the extent that those costs arose from the R&D activities. If the activities consumed 50% of utilities, it would stand to reason that half of the utilities must be added to the total 174 costs.

Indirect Costs vs. Incident-to Costs

The FASB defines indirect costs as those that cannot be directly linked or traced to a specific product, service, customer, or project but are necessary for the general operation of the business like marketing, legal, accounting, or administration. These are costs that may be “ratably attributed” to the activities of carrying on the trade or business.

In contrast, incident-to costs come from specific activities. With our automation company, is all the rent an indirect cost of carrying on the business, (Section 162) or is part of it an incident-to cost of the R&D activity requiring Section 174 capitalization? If the rent didn’t go up due to engaging in the R&D activity and it didn’t go down when that activity ceased, barring an unusual circumstance, the rent was necessary for carrying on the business. Therefore, it is not a 174 cost. It is an indirect cost of running the business.

Incident-to vs. Incidental Costs

It is easy for taxpayers and tax preparers to conflate the terms incident-to costs and incidental costs. But in business and accounting contexts, these terms are not interchangeable. While incident-to cost refers to a causal relationship with an activity, incidental costs refers to the size or significance of a cost in relation to a larger cost or activity. With our automation company, the small amount of water used in the R&D activity may be an incidental cost — small in relation to the entire R&D project — as well as an incident-to cost. However, if utility costs were large in relation to the R&D project and were also caused by the project, then the business’s utility costs would be incident-to the R&D project, but not an incidental expense of the project.

Our Takeaway

With our automation company, the facts and circumstances of a taxpayer would likely reveal that none of its rent or property taxes nor its common area maintenance would be expenses that were affected by the R&D project. However, the lighting, HVAC, and water usage could have been. Even insurance and security costs could be incident-to costs. Let’s assume the business purchased a rider on its insurance policy to cover the specific activities of the R&D project—that would be an incident-to cost. Correspondingly, if the R&D project required extra security measures, those additional costs would also be incident-to costs.

Incorrectly calculating incident-to costs could be significant to the business. For instance, what if our automation company’s $2 million in direct expenses for its R&D project had $3 million in indirect expenses for running the business? Conflating indirect expenses with incident-to expenses could lead to incorrectly recording $1.5 million (50% of indirect expenses) in additional amortization resulting in approximately $500,000 in extra federal taxes.

Section 174 is an old regulation, but it is new to most practitioners and taxpayers. The TCJA rule change has rightly caused alarm. While it is still debatable whether an R&D expense has to be amortized, it is important to not compound the problem by incorrectly adding business expenses to 174 R&D costs. As with all of accounting, the facts and circumstances of the taxpayer are critical to understanding how to apply Section 174 to a tax return. Consult your tax professional to determine which of your expenses must be included in the Section 174 calculation and which do not. Given that these are uncharted waters, it is important to carefully substantiate in writing why some expenses were excluded and others included.

Author Information

Rick Kleban is the founder and president of Sycamore Growth Group, an Ohio-based firm that specializes in helping small and medium-sized businesses attain and substantiate R&D tax credits.

James Bean is a senior analyst at Sycamore Growth Group, specializing in investigating clients’ tax issues.