Oddities of No §174 R&D Fix in 2022

I thought Congress would repeal or extend the Tax Cuts and Jobs Act of 2017 delayed change to §174 that changes from expensing R&D (the law since 1954) to capitalizing and amortizing over 5 years (domestic) or 15 years (foreign). After all, a key purpose of the TCJA was to make our tax system more internationally competitive. Providing a more unfavorable rule for R&D expenditures goes in the opposite direction. But it wasn't to be effective until tax years beginning after 12/31/21 (most TCJA changes were effective after 2017). So it was arguably more of a budget gimmick to reach the desired revenue loss target set for the TCJA. But, it was not delayed or repealed - although that might still happen.

Two observations:

1. Is expensing the right tax policy? I think so. Generally, a long-lived asset should be amortized over its useful life. But not all R&D has a life beyond one year and when it does, it is hard to estimate. So, I think economic growth and administrative convenience reach an appropriate result to just expense the R&D when incurred.

2. Capitalizing and expensing over 5 years is too long and sends the wrong message that R&D work in the U.S. is not valued. A recent report from the National Academies of Sciences, Engineering and Medicine entitled Protecting U.S. Technological Advantage notes in the first paragraph in the preface:

"U.S. leadership in technology innovation is central to our nation’s interests, including its security, economic prosperity, and quality of life. Our nation has created a science and technology ecosystem that fosters innovation, risk taking, and the discovery of new ideas that lead to new technologies through robust collaborations across and within academia, industry, and government, and our research and development enterprise has attracted the best and brightest scientists, engineers, and entrepreneurs from around the world. The quality and openness of our research enterprise have been the basis of our global leadership in technological innovation, which has brought enormous advantages to our national interests."

I think most people agree with that. Innovation, high-paying jobs, development of new technologies - are things we want to encourage in the U.S.

What do you think?

5th Anniversary of Tax Cuts and Jobs Act - 12/22/22

The Tax Cuts and Jobs Act (P.L. 115-97) was signed into law on December 22, 2017. This was a budget reconciliation bill so only needed 51 votes in the Senate rather than 60. Among many things, this means the official name of the bill has the word "reconciliation" in it (an act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018).

The TCJA was primarily intended to make the corporate tax system more internationally competitive by lowering the corporate rate (from a high of 35% to a flat 21%) and make the international system a semi-territorial one rather than worldwide.  But, not all businesses operate as C corporations and the TCJA included the §199A qualified business income deduction to provide a rate reduction for business income of sole proprietors, partners and others, with a few exceptions. But that provision is only in the law through 2025 while the 21% corporate rate is permanent (pending any congressional action to change it).

There are many temporary provisions in the TCJA, several of which are built-in tax increases. Here is most of that list.

• Beer, wine and distilled spirits – special rule on interest capitalization (§263A(f)(4) and excise tax rates was to expire 12/31/20 but was made permanent by CAA-21 (PL 116-260; 12/27/20).
• §45S, Employer credit for paid family and medical leave, terminated for wages paid in tyba 12/31/20, but was extended 5 years by CAA-21 (PL 116-260; 12/27/20) (to 12/31/25).
• Staring in tax years beginning after 12/31/21 businesses with R&D must capitalize their total R&D expenditures (§174) each year and amortize them over 5 years using the half-year convention (15 years for foreign research).  This is a BIG change since expensing has been the law since 1954. The effect is significant. For example, if a business had $100,000 or domestic R&D in 2022, rathe rather than expensing $100,000 in 2022, they can only expense $10,000 in 2022 and the balance is expensed (amortized) over 2023 to 2017).
• The §163(j) interest limitation calculation becomes less favorable for tax years beginning after 12/31/21 (depreciation, amortization and depletion will reduce adjusted taxable income).
• 100% bonus depreciation of §168(k) begins to phase down generally for property placed in service after 12/31/22 through 12/31/26. For 2023, it will be 80% bonus.
• The deduction for foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI) are reduced from 37.5% to 21.875% for FDII and from 50% to 37.5% for GILTI for tax years beginning after 12/31/25.
• Individual provisions expire after 2025 such as doubled child tax creidt, higher standard deduction, lowered brackets, SALT cap.
• The §461(l) business loss limitation for non-corporate taxpayers expires after 2028 (years changed to 2021 through 2028 by a few post-TCJA public laws).

If there are to be any changes to TCJA now or in very near future, I'd recommend:

1. Repeal the §174 change. It is simpler and better encourages R&D to allow for it to be expensed when incurred.
2. Remove the SALT cap for state and local taxes attributable to business income such as is on Schedules C, E and F. These business taxes should be deductible FOR AGI.
3. Make the Child Tax Credit fully refundable. 
4. Repeal the individual AMT.

What do you think?

New Year's Resolutions for Our Tax Systems

As 2021 wraps up we think about what we might do differently in 2022, I offer a few suggestions for improving state and federal tax systems.

1. Modernize tax systems: Computing and paying our taxes should be as easy as e-commerce, online banking, and email. Income taxes should be a just-in-time system where we select software we want to use to compute our tax liability regularly and we pay in or receive any overpayment at least weekly. This will work for businesses if your software accurately computes your taxable income with each transaction you engage in. Also, if you need to amend a return, just log into your account and adjust your return.

2. Simplify!: Why does our federal tax system have over 100 special rules (see the Joint Committee on Taxation list here)? We can easily get rid of the home mortgage interest deduction, especially today when less than 10% of filers claiming it. Move items out of the tax law that don't need to be there. For example, education provisions such as the lifetime learning credit and American Opportunity tax credit. Some of these encourage schools to increase tuition. And for individuals in need of financial aid, increase grants and scholarships.  Also, why are depreciation rules over 50 pages long? Simplify!

3. Prevent budget gimmicks: Starting for tax years beginning after 12/31/21, R&D expenditures are no longer currently deductible as has been the case since 1954. Instead, companies involved in innovation that produces R&D expenditures will have to capitalize these costs and amortize them over 5 years (15 years if it is foreign research). This change was in the TCJA with a delayed effective date to help reach the $1.5 trillion cost limit over 10 years. I don't think anyone expected it would become effective, but it will for calendar year businesses on 1/1/22. While the Build Back Better Act pushes out the effective date four years, it wasn't passed before 1/1/22. These items that are just to help a bill reach a revenue target over a 10 year period should be disallowed.

In the American Rescue Plan Act enacted in March 2021 (PL 117-2), we saw a budget gimmick repealed. This was the section 864(f) change added by 2004 legislation with a postponed effective date and further extended at least two more times to finally be repealed by 2021 legislation without ever going into effect! 

It is appalling that we start 2022 capitalizing R&D which should be incentivized and simplified to expense as incurred. It has worked well since 1954. Most countries offer tax incentives for R&D, we should too.  There are spillover effects with R&D that support some government support such as through expensing (and for some R&D, the research tax credit).

4. Allow tax law improvements without 60 votes in the Senate: The budget reconciliation process limits what can go into a tax bill. For example, it can't have anything to do with Social Security. Provisions need to deal with revenue. Thus, no technical corrections, removal of "deadwood", preparer regulation and many other items. It seems to also prevent many needed reforms, such as simplification. A few years ago the AICPA suggested 13 proposals to truly improve the tax law to reflect how small businesses operate today. I think it is unlikely thought we will see these reforms or similar type improvements when Congress has to use the budget reconciliation process. Of course, bi-partisan efforts to improve the tax system such as occurred in 1986 would also be good.

5. Make the personal income tax work like a personal income tax: Notice 2020-75 that allows even optional state taxes imposed on partnerships and S corporations to be deducted on Schedule E where there is not $10,000 SALT cap is very poor tax policy. Such a workaround causes lots of confusion and complexity as we see by the laws in the roughly 22 states with these optional taxes all operate differently. A "normal" personal income tax includes all income with deductions for a standard deduction and personal/dependence exemptions and the expenses of producing income, such as state and local income taxes. The $10,000 SALT cap is not proper policy and treats C corporations better than other types of business entities for no good policy reason. 

6. Expand high school curriculum to include taxation basics: It is just wrong that many people first learn of taxes via their first paycheck. Why do we teach about the three branches of government and their functions but not how they get their funding? A key responsibility of citizens is to pay taxes. Why not teach the basics of taxes, government budgets and even basic tax policy (such as how different types of taxes are supposed to work), in high school? I think this would enable people to ask better and needed questions of elected officials and those running for office. For example, many people in California should have been asking lawmakers why they made the temporary sales tax exemption on baby diapers permanent this year (AB 150). To those who don't know a lot about taxes and data, this exemption probably sounds good. But the biggest benefit goes to higher income individuals who spend more on diapers (because they can) and don't need an exemption. Before the original diaper exemption was enacted a few years ago, the California Legislative Analyst's Office told lawmakers that it would not do what they thought (help low income individuals). The $70 million cost of this exemption would be much better used to fund child care for low-income workers. That would be a better benefit to the economy as well.

#letsfixthis

What do you think? What would you add?

Happy New Year!

A more temporary tax system

For at least the past decade, our federal tax system has had several temporary provisions. That is, rules added to the law with an expiration date. Many of these items are credits that often are not included as permanent items because they tie to economic stimulus or temporary energy needs (such as promoting alternative fuels by lowering their cost). Another reason for temporary provisions that result in less federal revenues is that they don't "cost" as much in a 10-year budget window if in existence for one or two years rather than for all ten years.

The Tax Cuts and Jobs Act (P.L. 115-97 (12/22/17) has increased the number of temporary provisions in the law. Most notably, most of the individual tax cuts, such as lower rates, a higher standard deduction and child credit, as well as lost deductions such as interest on home equity debt and casualty/theft losses, are only in the law for eight years (2018 through 2025).

Each January, the Joint Committee on Taxation (JCT) publishes a list of all temporary provisions and when they expire. Below I have a summary of the number of expiring provisions identified in their January 2017 report and the one issued in January 2018.

Year	2017 JCT Report	2018 JCT Report
2016	36	34*
2017	2	1**
2018	1	3
2019	10	9
2020	1	1
2021	4	3
2022	2	2
2023	1	1
2024	0	0
2025	1	23
2026	0	2
2027	0	1
TOTAL	58	80

As you can see, we go from 58 temporary provisions last year to 80 temporary ones today. Also, the number is really higher each year because the JCT combines some similar items, such as various empowerment zone tax incentives.

Missing Item: I think the number for the 2018 report is missing at least one new temporary item.  P.L. 115-97 provides that for tax years beginning after 12/31/22, taxpayers may no longer follow Code section 174(a) on expensing of R&D expenditures. Instead, such costs must be capitalized and then amortized over 5 years (15 years for foreign research). Thus, I think we really have 4 temporary items expiring in 2021 because section 174(a) should have been included.  Also, I expect that Congress will find a way for this capitalization provision to never go into effect. Favorable treatment of R&D expenditures should be in our tax law for a few reasons: simplification, incentivizing R&D, and international competitiveness.  So, why did Congress add a provision that harms economic growth?  Likely to help generate revenue to help reach the $1.5 trillion cost of tax reform without going over that amount.

What do you think?

*Includes section 199(d)(8) for certain Puerto Rico benefits. P.L. 115-97 repeals section 199 effective for tax years beginning after 12/31/17, so this temporary item is only relevant for possibly seeing Congress renew it for 2017. An item removed from the 2016 for the 2018 report is the 7.5% threshold for deducting medical expenses for individuals age 65 or over. It got moved to the 2018 list because for 2017 and 2018, all individuals use a 7.5% threshold for both regular tax and AMT.

**Airport excise taxes were renewed one year by 2017 legislation (so got moved to the 2018 list for the 2018 JCT report.