Whether it is manufacturers, clothing designers, software developers, plant breeders, winemakers, or engineers, businesses across New York State are shocked to hear how significantly their federal tax bills are increasing for the 2022 taxable year even when their earnings remain the same. It is every accountant’s nightmare to explain that the ability to immediately deduct research and experimental (“R&E”) activities is no longer available for federal budget reconciliation reasons. Instead, R&E costs must be spread over 5 years (or a 15-year period if foreign research).
The shock and eventual anger of taxpayers rises as they remained loyal to New York State by keeping their businesses in the state and desired to help increase job creation through innovation and research. However, many feel they are now being punished with increased federal tax bills for trying to create instead of repeating old processes. It is the exact opposite of what other economically developed countries around the world do. The United States federal tax law punishes companies for trying to lead innovation and market growth. To learn more, click here:
The capitalization of federal R&E expenditures may result in more companies moving out of New York to balance their federal and New York State tax bills. One of the main attractions for New York businesses is the highly educated and talented workforce. New York is consistently rated as one of the top ten most highly educated states in the United States. However, if out-of-the-box thinking, innovation, and growth are impeded by the requirement of R&E capitalization and the normal company investment allocation for R&E diminishes, could New York become less desirable?
The definition of what is considered a research and experimental expenditure is broad.
R&E Expenditures are incurred in connection with the taxpayer’s trade or business and represent research and development costs in the experimental or laboratory sense. Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.
The broad definition encapsulates many businesses. For those who think R&E only impacts multi-national corporations involved in pharmaceuticals and technology, think again. Many privately owned small and mid-size businesses are being stripped of much-needed cash due to activities they initially became involved in to make their businesses better.
The following examples represent businesses where the required R&E capitalization has negatively impacted their business. For example, a manufacturer exploring different add-ons to the manufacturing line to increase efficiency, eliminate error, and increase employee safety was deemed to incur R&E expenditures. A clothing designer who decided to transition to a different eCommerce platform to increase client exposure, customer experience, and site speed also was deemed to have R&E expenditures. Software developers that are in the early stage of evaluation for design ideas to launch new sports websites, as well as improving the existing statistical analysis of their client’s key performance indicators, were required to be capitalized their investment over five years. Most expenditures incurred by plant breeders that assist in developing new plant varieties to ensure resistance to pests, pathogens, and drought now must be deducted over a 5-year period. Engineer expenditures related to the production of models to accurately represent the design to complete the project, as well as the review of design drawings, and exploration of different building designs to ensure technical certainties are met for each engineering project, would also be required to be capitalized for R&E purposes.
All of these examples fall under the definition in that there was no clear path for these enhancements, creating uncertainty, and therefore result in R&E expenditures requiring capitalization. And the cash impact on these New York companies is extreme. For example, the clothing designer reported a financial statement loss of $ 2 million, but primarily due to the R&E capitalization requirement of the eCommerce platform drove their taxable income up by $1.7 million, resulting in additional tax due of over $350,000. The software development company reported a financial statement loss of approximately $1 million, but due to the required R&E capitalization increased their federal taxable income by $2.2 million resulting in an additional $462,000 of federal income taxes. For two companies that would have paid little to no federal income tax due to their investment in their businesses, and actual cash outlay for research expenditures, they are now struggling with where to find the cash for their federal income tax payment. This limits their ability to expand into new markets, hire additional personnel, invest in capital improvements, and continue to grow their business.
So what will happen if the R&E capitalization requirements continue? New York state business growth will be stunted and cash will have to be redirected to pay federal income tax bills. Retailers may limit their expansions, software developers could limit the number of improvements to existing software or development of new software, farmers could be forced to utilize seeds that are not as highly resistant as what is needed for the ever-changing environment, and engineers may not want to invest so much time in design and models when completing projects. Does this seem extreme? Maybe. But for small and mid-size businesses, there is no excess cash flow to absorb the burden of increased federal income tax bills. Therefore, many companies will have to reevaluate their investments to maintain the status quo.
And so, we hope that our federal representatives realize the impact federal R&E capitalization could have on business growth, expansion, and investment. While there is a bi-partisan divide between many Congressional leaders, the need for partisan support to ensure America continues to be a leader in innovation and research is essential. I fear that many Congressional leaders may not understand the immediate, but also prolonged impact, that the R&E capitalization requirement will have. I can only hope that some of the client’s stories highlighted, will awaken and motivate Congressional leaders to ensure immediate expensing of R&E expenditures so that the U.S. remains a global innovation leader. After all, tax policy is an important motivator for businesses to innovate. Many believe that a significant reason Switzerland continues to rank as the top global innovative country in the work for the 12th year in a row is related to their various tax law supporting innovation and intellectual property.
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