Before discussing the impacts of research & development (R&D) and amortization, it’s essential to understand these concepts fully. Amortization is the process of spreading payments over some time. Loans and intangible assets can be amortized. R&D is a general term that applies to numerous areas. In its simplest definition, it is the creation of new knowledge. Regarding business contexts, R&D involves developing innovations among services, processes, and products. It’s based on innovation to generate revenues and stay competitive.
Related: Find Out Just How Much the R&D Credit Can Reduce Your Taxable Income
Amortization of Tax Credits
Another plus of R&D is the tax credit that comes with it. The Protecting Americans from Tax Hikes (PATH) Act was passed in 2015. Embedded in this was the Research & Experimentation Credit, known as the R&D tax credit. This was especially beneficial for startups, and small businesses as the credit can be claimed for innovation and research. This significantly reduces a business’s tax bill and development expenses. In turn, it acts as an incentive for companies to invest in long-term R&D.
This tax credit can be carried one year back but up to 20 years forward. Businesses that invest heavily in R&D for their first years can generate profit benefits by amortizing the credit. As revenues increase, organizations will see the financial perks over time.
New or groundbreaking findings are not necessary to claim this beneficial credit. Qualified research activities are subject to a simple, four-part test to determine if their activity is applicable, including:
- · Activity improving a new or existing product and/or service
- · The research eliminates the uncertainty of improvement
- · The research follows a process
- · The activity is related to engineering or a biological, physical, or computer science
Qualified research expenses (QRE) can be in-house or contracted expenses. The former includes wages and leasing expenses. The latter includes claiming up to 65% of payments made to independent contractors or 75% to approved research entities such as universities.
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Breaking Down the R&D Credit
The so-called R&D Tax Credit is not just one fiscal break but comprises specific subcategories. It is available to all businesses on a federal level and can be claimed at the state level. Companies can choose to claim the Alternative Simplified Credit (ASC) or the Regular Research Credit (RRC). A whopping 60% of businesses claim the ASC since it allows for the claiming of more QREs. Specifically, 14% of the fiscal year’s expenses add more significant financial benefits in the long run. Startups without prior QREs can claim 6% of the year’s current expenses on the ASC.
The RRC is based on historical percentages, making it a feasible option for established businesses. A company can claim 20% of QREs from the current year, but the calculation for the credit is based on the average gross over the past four years.
The Basic Research Credit applies to non-profit entities and pays them to conduct research. Universities are prime candidates for this credit as they focus on advancing knowledge outside commercial applications. Finally, the Energy Research Credit is available strictly to non-profit organizations dedicated to advancing energy research. Businesses can claim a portion of research expenses and no base amount is needed to qualify for the credit.
Updates Create New Impacts
Recent changes to the R&D Tax Credit will generate new impacts regarding the amortization of research assets. On May 4th of this year, the United States Senate preserved the credit through two pieces of legislation: the America COMPETES and US Innovation and Competition Acts. The hope behind the 90-5 vote was to let businesses take advantage of the lucrative tax credit in and beyond 2022.
COMPETES stands for Creating Opportunities for Manufacturing Pre-Eminence in Technology & Economic Strength. It provides funding for the domestic production of semiconductors and addresses supply chain weaknesses. The biggest perks of this act are $52 billion going to American conductor production and $45 billion to combat shortages of crucial goods. That is a combined $97 billion companies can amortize for two decades of increased revenues.
The Innovation & Competition Act is a proposed law that calls for a nationwide strategy focused on economic security, job growth, and scientific advancements. It also creates a symbiotic relationship with the National Science Foundation. These developments mean companies can double the value of the R&D tax credit as they can deduct even more expenses, thus reducing their taxable income. The ultimate hope is the option of amortization will prompt more US-based R&D efforts.
Related: Curious about how much money an R&D credit could save you? Have a look at Tax Hack’s online calculator.
Short Term vs. Long Term
Other legislative changes to R&D tax credits include that beginning in 2022, companies must amortize R&D expenses over at least five years. This is intended to boost short-term federal tax revenue. Yet this tactic does not offer long-term economic benefits. Legislatures are still examining the impacts of this change, and an option being considered is delaying the amortization of R&D expenses until 2026. This delay could generate around $223 billion in a 10-year window, but it would not generate long-term economic growth.
Ceasing R&D amortization would increase the GDP and incomes by just 0.1 percent while reducing federal revenues by around $213 billion. Delaying amortization until 2026 would not increase the long-term GDP but could increase revenues by roughly $11.2 billion over a decade. If R&D amortization is delayed by 1-3 years, revenue would slightly increase, but there would be no long-term benefits.
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What’s on the Horizon
It is possible that upcoming legislation could increase the value of the R&D tax credit twofold and allow even more organizations to enjoy its numerous benefits. There is also an option for businesses to deduct R&D costs each year instead of amortizing deductions. If this comes to pass, it allows companies to deduct expenses based on their terms. Tax strategies can change over time as revenues ebb and flow. Amortization has pros and cons, but it is more of a gamble for young companies who cannot yet determine what the future holds.