In brief

The federal 2017 tax reform act enacted changes to Section 174 applicable for tax years beginning after 2021.  Companies computing their first-quarter state income tax estimated payments should be aware of the state income tax implications associated with the federal changes. Consequences extend beyond the threshold question of state conformity to Section 174. Companies also should consider state conformity to, and treatment of, Section 280C, the potential for state subtraction modification for disallowed federal deductions, and the impact to a taxpayer’s Section 163(j) limitation.

State tax impact: Special consideration should be given to the potential for state subtraction modifications available for deductions disallowed for federal purposes relating to a credit that is not available for state purposes. Opportunities may be available in certain states for taxpayers that do not make a Section 280C election, which results in a decreased or disallowed federal deduction.

Note: Congress currently is considering legislative proposals with bipartisan support that would reinstate on a temporary basis the prior Section 174 treatment of “research or experimental” (R&E) expenditures or would repeal the 2017 tax reform act changes to Section 174.  As noted below, if such federal tax legislation is enacted, not all states will immediately conform to the federal legislation.

In detail

Section 174 changes applicable in 2022

Historically, Section 174 allowed taxpayers to currently deduct R&E expenditures. Taxpayers alternatively could elect to treat R&E expenditures as deferred expenses that are deducted ratably over at least 60 months or as capital expenditures that are amortizable over a useful life, if determinable. Taxpayers choosing to deduct R&E expenditures also could annually elect under Section 59(e) to recover the costs over a 10-year period.  Similarly, Rev. Proc. 2000-50 provided that software development costs could be deducted currently, capitalized and amortized over five years, or capitalized and amortized over three years (with or without bonus depreciation).

The 2017 tax reform act amended Section 174, effective for amounts paid or incurred in tax years beginning after December 31, 2021, to eliminate current-year deductibility of R&E expenditures and software development costs (collectively, R&E expenditures)  and instead require taxpayers to charge their R&E expenditures to a capital account amortized over five years (15 years for expenditures attributable R&E activity performed outside the United States).

State tax conformity to the Internal Revenue Code (Code) generally

The threshold state income tax question is whether and how a state conforms to the Code. States that begin the determination of state taxable income with federal taxable income generally do so in three distinct ways, each of which brings with it unique state income tax consequences. How a particular state adopts the Code directly affects the application of enacted federal changes to its taxable income computation.

Rolling conformity – Immediate conformity

States that explicitly conform to or adopt the Code “as in effect” will incorporate, for the same tax years, changes made to the Code. In other words, a federal change enacted and effective for the 2022 tax year will be incorporated into the 2022 tax-year provisions of a rolling conformity state.

Specific-date conformity

States that explicitly adopt the Code as of a fixed date will conform to the Code as of that date.  To the extent there are legislative changes after that date, a fixed conformity state would have to enact conforming legislation if they want certain Code provisions to apply.

Code-specific conformity

States that adopt particular Code sections have issues similar to specific-date conformity states. Taxpayers in these states will have to analyze federal changes for each Code section and determine whether to adopt the federal provision.

State conformity to Section 174

The threshold consideration for taxpayers is to consider whether a state conforms to the federal 2017 tax reform act changes to Section 174.

State conformity to new federal provisions is generally a matter of concern when a Code change has a relatively immediate impact. If states do not act to confirm prior to the applicable date of the change, then there could be a disconnect between federal and state treatment. In the subsequent state legislative session, states typically update conformity to include federal changes on a prospective if not retroactive basis (e.g., the 2020 CARES Act) and/or evaluate whether to follow or decouple from certain provisions (e.g., Section 168(k) bonus depreciation).

In the case of Section 174, the federal changes were enacted at the end of 2017. In the more than four years since enactment, specific-date and Code-specific states have had the opportunity to formulate their treatment of changes from the 2017 tax reform act that are applicable to the 2022 year.  As a result, most states have conformed to the changes made to Section 174 either due to rolling conformity, specific-date conformity that includes the 2017 tax reform act, or Code-specific conformity that adopts Section 174.

However, there are exceptions. For example, California generally adopts the Code as of January 1, 2015, which would not include the changes to Section 174. Wisconsin adopts Section 174, but specifically states it is the version that existed prior to the 2017 tax reform act.

State conformity to Section 280C

Section 280C(c) generally provides that a taxpayer cannot take the benefit of a Section 174 deduction and an R&D credit measured by that same Section 174 deduction. Therefore, a taxpayer either (1) under Section 280C(c)(1) reduces the amount of amortizable Section 174 and takes the full R&D credit (this is the default) or (2) under Section 280C(c)(2) elects to capitalize the full amount and amortize it as allowed and reduce its R&D credit.

State conformity to Section 280C should be considered because computational challenges occur if a state conforms to Section 174 but not to Section 280C.  South Carolina, for example, conforms to Section 174 but decouples from Section 280C.  Therefore, the default operation of Section 280C would decrease a taxpayer’s federal Section 174 expense deduction but because Section 280C treatment is not adopted in South Carolina, that taxpayer may be able to take the entire deduction as if Section 280C did not apply.

Observation: There is uncertainty as to the application of the revised Section 280C language at the federal level that may need to be resolved through either administrative guidance or a legislative technical correction. Some practitioners have taken the position that in certain fact patterns Section 280C may not result in a reduction to the amount charged to a capital account for research expenditures even when a reduced credit election is not made, or that the reduction may be less than the credit amount. Assuming that the Section 280C election does result in a reduction to the amount charged to a capital account, there are the following state tax considerations.

Impact to a state’s R&D credit

An issue may arise in a state that conforms to Section 174 and has its own state-specific R&D credit. If so, then a question arises whether a state has a Section 280C-type rule that precludes a taxpayer from taking both the Section 174 deduction and a R&D credit that’s measured by the same Section 174 expenses. Without such a mechanism, a taxpayer may be able to claim both a reduction in taxable income due to the Section 174 deduction and the state R&D credit to the extent a portion of it is measured by the same Section 174 amount.

State subtraction for “disallowed” federal deductions

For federal tax purposes, an expense may be disallowed due to its relationship with a federal credit. If that federal credit is not available for state tax purposes, then some states allow a subtraction modification measured by such expense. As mentioned above, Section 280C(c)(1) provides that a taxpayer reduce its Section 174 deduction (or starting in 2022, the amount capitalized and subsequently amortizable) measured by the Section 174 amount included in its federal R&D credit. Alternatively, a taxpayer may elect to reduce its R&D credit and maintain its Section 174 deduction.

Some states allow for such a subtraction modification. For example, Oregon provides that if “a taxpayer has taken a federal credit, which requires as a condition of the use of the federal credit the reduction of a corresponding deduction or basis, and the federal credit is not allowable for Oregon purposes, the taxpayer shall be allowed the deduction or appropriate adjustment to basis to derive Oregon taxable income.”

Observation: Companies not taking the federal Section 280C election should review whether similar opportunities may exist in other states.

Observation: The question arises whether the 2022 Section 174 change to amortize deductions should be viewed as a “disallowed” deduction. Although a taxpayer’s Section 174 deduction may be reduced in a particular year due to the amortization, the deduction in effect is delayed and spread across several years rather than being denied.

Section 163(j) impact

The requirement to amortize Section 174 expenses starting in 2022 may result in some taxpayers having a less-than-expected Section 174 deduction in 2022. Additionally, starting in 2022 Section 163(j) removes depreciation and amortization from the calculation of adjusted taxable income.  As a result, a taxpayer’s adjusted taxable income as determined for Section 163(j) may increase, which would allow for a greater amount of Section 163(j) business interest expense deduction.

Observation:  State conformity to such changes should be considered to identify whether a modification is needed.

Software development costs

As noted earlier, the 2017 federal tax reform act amended Section 174 to provide that, starting in 2022, R&E expenditures include amounts incurred “in connection with the development of any software.” However, Rev. Proc. 2000-50 provides that the IRS “will not disturb a taxpayer’s treatment” of software development costs that were treated consistently with Section 174.

Observation:  Rev. Proc. 2000-50 provides that “[t]he costs of developing computer software (whether or not the particular software is patented or copyrighted) in many respects so closely resemble the kind of research and experimental expenditures that fall within the  purview of 174 as to warrant similar accounting treatment.”  Even if taxpayers have been treating software development costs as Section 174 expenses, in light of the 2017 act requirement to capitalize Section 174 expenses starting in 2022, taxpayers may wish to consider analyzing whether these expenses are software development expenses under Section 174 could be treated as ordinary and necessary business expenses under Section 162.

Looking ahead

Taxpayers experienced challenges with the March 27, 2020, enactment of the CARES Act, which impacted prior tax years.  For specific-date conformity states that were not able to move conforming legislation through their legislatures (for reasons including that legislative sessions may have already ended) significant federal/state differences resulted.  Additionally, if conformity legislation was not clear on applicable dates, then uncertainty arose regarding whether states conformed to CARES Act changes retroactively or prospectively only.

As noted, in recognition of the potential economic benefits that result from R&E activities, legislation is under consideration in Congress that would reinstate on a temporary basis the previous Section 174 treatment of R&E expenditures or would repeal the 2017 Act changes to Section 174 that require capitalization.  For example, the House-passed Build Back Better bill would defer for four years the effective date of the 2017 capitalization requirement.  If that bill were enacted, taxpayers with E&E expenditures paid or incurred in tax years beginning before 2026 would continue to have the earlier options for federal income tax purposes.

If such federal legislation is enacted, not all states will immediately conform to changes.  Taxpayers in states that do not conform to these changes, or where conformity is unclear, may be faced with federal and state tax differences that complicate their state tax calculations.