The chairman of the Ways and Means Committee, Rep. Kevin Brady (R-Texas) and the chairman of the Finance Committee, Sen. Orrin Hatch (R-Utah) as well as the White House have recognized that the current level of economic growth is unacceptable and that tax reform must encourage a stronger economy and faster growth.
To their credit, the tax reform proposals put forward by Brady and Hatch do much to spark increased economic growth – with bonus depreciation/expensing of business equipment encouraging investments in new equipment that will enhance productivity and result in higher wages for workers. Reduced productivity has been a disappointment this past recovery, and encouraging higher productivity in the future will be the key to a higher standard of living. In addition, the lower corporate rate and rate for pass-throughs will go far in rekindling the entrepreneurial spirit that has been dampened in the last few years as well as making us competitive internationally.
Unfortunately, along with all this good news in tax reform for business and workers – there is a cloud. The cloud comes in the form of a provision in both the House and Senate tax reform that requires companies to amortize R&D expenditures over a five-year period (starting in 2023 for the House costing businesses $108 billion; and 2026 in the Senate costing $62 billion). Real dollars. Allowing expensing for purchases of equipment (as provided in the House and Senate bill) encourages new equipment purchases and improved productivity, but requiring amortization for research will hit the bottom line hard for innovative companies – and will discourage both basic and applied research.
The amortization of R&D expenses runs counter to all the good proposals in the House and Senate tax reform bill – and eats into the seed corn of future improvements and inventions that will continue to propel strong economic growth for our country. In particular, amortization of R&D casts a shadow over small and medium companies.
An example can best bring home this reality: Assuming a 20 percent rate – business owner Jane has $1,000,000 of qualified research expenditures (QREs) under Section 41 of the Internal Revenue Code. Jane uses these QREs to generate a gross Research and Development tax credit of $100,000. Jane must reduce her deductions by the amount of the credit ($100,000). The remaining $900,000 in deductions must also be added back into Jane’s income and amortized over 5 years, beginning at the midpoint of the year. The resulting increase in income is thus $910,000 ($100,000 credit + $900,000 in expenses – $90,000 1st half-year’s amortization). Jane’s tax liability goes up $182,000 ($910,000*.2) and is then reduced by the $100,000 credit. As a result of claiming the credit, Jane’s ultimate tax liability is increased by $82,000 ($182,000-$100,000).
Thus, instead of receiving a benefit of $80,000 from the Research and Development tax credit under current law – because of amortization Jane will owe $82,000. That’s a swing of $162,000 – with a 20 percent rate (the situation will be worse for those pass-through businesses that will pay a higher rate than the corporate 20 percent rate). Not a good result for Jane and other innovative companies.
Tax reform should encourage and reward companies to take risks, experiment and create the new thing – all while making products quicker, better, cleaner and more cost-efficient. That is what the R&D tax credit rewards – and I know that is what Congress wants to prioritize in tax reform. But Congress needs to have its eyes open to the detrimental impact that amortization of R&D expenditures will have in discouraging investments in new companies as well as expanding innovative companies. Further, it will send the wrong signal to companies about engaging in applied and basic research. This is particularly so with small and medium companies that in many cases are now looking at taking the R&D tax credit for the first time – thanks to the great work of Brady and Hatch as well as Sens. Chris Coons (D-Del.) and Pat Roberts (R-Kan.) in the Path Act in 2015 that significantly expanded the ability of small and medium businesses to utilize the R&D tax credit. Many small and medium businesses will view amortization of R&D as a barrier-to-entry for them causing more to deter decisions on engaging in basic and applied research. The decision to conduct research will weigh even heavier the closer in time that amortization is required.
I know many of my former colleagues will consider the amortization of R&D as a placeholder that will never see the light of day. But small and medium businesses do not have armies of lobbyists and government specialists at their elbow to which they can turn. Small and medium business owners are busy people and they will know what they read and what is in the law.
My former colleagues need to be aware of the problems this proposal for amortization will cause. It’s a problem that can be easily avoided without undermining all the good in the tax reform bills. With this change Congress can pass a tax reform bill that will encourage a strong economy, higher productivity, investment and innovation leading to good jobs at good wages.
About the Author
Former Congressman Rick Lazio recently became the Senior Vice President of alliantgroup, a national tax consultancy. A longtime advocate of small to mid-size businesses, Lazio spent his four congressional terms sponsoring pro-business initiatives such as the Small Business Tax Fairness Act of 2000. After his time in Congress, he held several positions in the private sector. He worked as Executive Vice President and later the Managing Director of the Assets Group at JP Morgan. Rick also served as a partner at Jones Walker LLP, a national financial services law firm, and headed the firm’s National Housing Finance Practice group. He serves on the Board of Directors for Enterprise Community Partners and the Bretton Woods Committee. He also has been an active member of the Committee for Economic Development and the Association for a Better New York (ABNY). Lazio is involved in numerous other business, philanthropic and civil organizations.