Taxes are one of the most significant expenses for many small businesses, so when the government changes tax laws, it can have a big impact.
The good news for 2023 is that it seems unlikely that there will be any major tax legislation coming our way. However, thanks to some of the expiring provisions from 2017′s Tax Cuts and Jobs Acts, some small businesses could already be facing a significantly higher tax bill this year for two big reasons.
Research and development expenses are less deductible.
The first has to do with research and development (R&D) expenses. These expenses are generally costs related to a company’s efforts to develop, design, and enhance its products, services, technologies, or processes. Examples of these costs include salaries, contractors, equipment, computer software, materials and overhead expenses. Although more common in such industries as pharmaceuticals and technology, just about any company in any industry can have eligible R&D expenses if it is making a new product or updating an existing one.
Until recently, a business could fully deduct those costs in the year they were incurred. But no more.
Starting in 2022, a business now has to amortize — gradually write off — those expenses over five years and can deduct only 50% of those expenses in the first year. If the research is performed outside of the country, that amortization period is 15 years. New Jersey and Delaware comply with the federal rules. Pennsylvania complies with the federal law, but the calculation is more complicated for calculating personal income taxes.
There were numerous attempts by business groups and professional associations last year urging Congress to delay this change, but none have succeeded. As recently as last month, the American Institute of Certified Public Accountants issued another plea to specific Senate and House representatives, to extend the original provision from the 2017 legislation to 2026 to allow “for simplicity in tax compliance and the minimization of confusion related to identifying costs that should be capitalized versus expensed.”
Nothing has happened yet, and many tax professionals aren’t optimistic.
“The change was a big surprise to some of our clients,” said Mitch Gerstein, a senior tax adviser at Isdaner & Co. in Bala Cynwyd. “And it has a big impact. Because of this change, on $1 million of R&D expenditures, only 10%, or $100,000, will now be tax deductible and taxable income will increase by $900,000.”
Gerstein says the change has created “a level of agita” because of the delay in providing guidance and the added cash flow concerns resulting from unbudgeted additional tax dollars. He’s advising his clients to pay the taxes and extend their tax returns to later this year with the hope that Congress will act sooner and delay the change.
Bill Burns, a partner at accounting firm EisnerAmper in Center City, has the same level of concern.
“The biggest conversation we’re having with our clients is around cash-flow planning,” he said. “A typical company may have profit, and then they reinvest that profit in R&D where they could expense the entire amount. This is a big disincentive.”
Like Gerstein, Burns says he’s also telling his clients to extend their returns even though the odds of Congress changing the rule “aren’t high.”
Depreciation on new purchases is limited.
As if losing out on one significant deduction isn’t tough enough, there’s another popular business tax deduction that will start being phased out this year: “bonus” depreciation. That’s a rule allowing most small businesses to deduct up to 100% of the cost of new assets purchased — equipment, machinery, computers, software and furniture — in the first year they buy it, as long as it’s placed into service that year. Unfortunately, that percentage has dropped to 80% in 2023.
“It means that many of our clients will not be able to deduct as much they did in the past for the purchase of capital items,” said Gerstein. Unfortunately, it gets even worse: The bonus depreciation deduction decreases to 60% of eligible capital expenditures in 2024, then 40% in 2025, and 20% in 2026.
“So even though it’s less this year, we’re telling our clients to take advantage of the deduction before it goes down even more,” said Gerstein.
To help ease the pain of this reduction, many accountants such as Gerstein are also recommending that small-business owners look at the costs they’ve incurred for purchasing a property and segregate those costs between the building costs and the equipment that’s part of a building. This can sometimes help businesses realize tax savings quicker, because the depreciation years for some of that equipment — sprinkler and plumbing systems, for example — may be less than the typical 27 years of a building.
Some good news
Despite being limited on what can be deducted for research and development and capital equipment expenditures, the tax news isn’t all bad for small businesses.
Even though it provides more than $80 billion in funding for the IRS — which some fear will increase the probability of audits — the Inflation Reduction Act, which was passed last August, has some tax incentives for businesses investing in green energy products and purchasing electric vehicles. It also allows more small businesses to use the research and development tax credit (a federal credit on certain research and development expenditures that could possibly be used to offset some of the impact of the above research and development tax deduction) against their employer payroll taxes.
Regardless, the negative impact of the now-limited research and development and “bonus” depreciation deductions could likely outweigh those benefits.
“These changes could result in substantially higher taxes from our clients in the manufacturing, software development, pharmaceutical and other industries and may have a negative impact on the extent of research and development activities in the future,” said Gerstein. “I hope Congress takes action.”