CPAs and their clients have been dealing with uncertainty surrounding Section 174 legislation for the last few years. Under the Tax Cuts and Jobs Act of 2017, research expenditures under Section 174 were required to be amortized over five years starting in 2022. This ruling negatively impacted taxpayers in manufacturing, engineering and other industries. Due to the punitive nature of this provision, few tax experts or legislators ever expected this to come to reality. Unfortunately, as of today, the federal government has not been able to fix this provision.
On January 31, Congress took the first step to fix this situation by passing H.R. 7024, the Tax Relief for American Families and Workers Act of 2024. This bill would restore 174 expensing for U.S.-based research and development, reset the 163(j)-limitation index to EBITDA, and extend 100% bonus depreciation. Under this legislation, these provisions would be extended through the end of 2025, providing significant relief to businesses nationwide. Unfortunately, this bill has stalled in the Senate even with bipartisan support.
Now that tax season has closed, the uncertainty of legislation creates a dilemma for CPAs. Should they have finished tax returns when they don't have all the answers? And how should they continue to communicate this issue to clients? The short answer for most tax preparation companies is that they must move forward based on the law as it currently exists. This means completing tax returns, estimates and extensions as if the Tax Relief for American Families and Workers Act will not pass. This allows CPAs to complete returns, or for clients that desire to go on extension, file correct estimated payments.
Many will ask what happens if this bill passes after a return is filed. This can be a big deal for taxpayers. Although not all taxpayers are subject to 174, almost every business is impacted by the changes to bonus depreciation. If this passes, taxpayers will have the opportunity to either amend or supersede a return, or file a 3115, presenting a tax planning opportunity for CPAs to determine the best year for taxpayers to take advantage of the changes.
In the meantime, 174 amortization requirements are becoming a major issue for many companies as they are causing a significant tax burden that companies may not be able to handle. This is further amplified by high interest rates, which can result in higher interest rates on bank loans. One possible solution is to consider changes in depreciation to make up for the shortfall. Real estate owners may be able to use a cost segregation study to create deductions that can offset the 174 tax increase.
Let's consider a manufacturing company that spends $2 million annually on 174 expenditures. The change requiring 174 amortization in 2022 meant that instead of deducting $2 million, they were limited to $200,000, creating an additional $1.8 million in taxable income. This unexpected increase in taxable income would have put a considerable burden on the company. Assuming a 30% tax rate, they would have been required to pay an additional $540,000 in taxes for 2022.
To address this the company reviewed their assets. In 2018, the company purchased a building for $18 million. They completed a cost segregation study that found approximately 20% of the $18 million could be moved to shorter lives. This resulted in around $3.6 million of bonus-eligible assets, which allowed them to file a change in accounting method with a "catch-up adjustment" of nearly $3.3 million. This adjustment more than offset the additional tax liability caused by the 174 amortization requirement.
This example demonstrates how examining cost segregation and other deductions can help mitigate the uncertainty companies face due to unpredictable tax bills. It's important to note that this doesn't imply that we should stop advocating for Washington to address these issues and pass H.R. 7024. However, in the meantime, there are opportunities taxpayers can consider to offset the financial burdens of 174 amortization requirements.
