Executive Corner: The Impact on Valuation of Section 174 Changes (R&D Expense Deductibility)
Although the research and development (R&D) tax credit has existed since the 1980s, it’s only been during the last decade or so that evolution in the tax code has expanded eligibility for this credit and popularized the tax strategy among architecture, engineering and environmental-consulting firms.
Tax Liabilities Coming Due
For years, many A/E firms developed systems for identifying and tracking eligible research and experimentation expenses and have benefited from the associated tax credits allowed under Section 41(d) of the tax code. However, the 2017 Tax Cuts and Jobs Act (TCJA) amended IRC Section 174, which governs the deductibility of these expenses, creating substantial and unbudgeted tax liabilities for many firms. These changes became effective for the calendar year 2022 forward.
In simple terms, the amendment requires that research and experimentation expenses now must be capitalized rather than expensed in the period incurred. The capitalized costs must then be amortized over five years (15 years for foreign expenses). This change in the tax treatment of these costs applies irrespective of whether a firm has applied for and/or received R&D tax credits. In addition, if the R&D tax credit exceeds the associated deductible research and experimentation expenses, the capitalized expenses must be adjusted downward by the excess.
Lobbying for a Return
Industry professional associations such as the American Council of Engineering Companies (ACEC) have supported bipartisan legislation that would restore the ability to deduct these expenses in the tax year they were incurred. These various bills include the American Innovation and R&D Competitiveness Act of 2023 (H.R. 2673); its senate equivalent, The American Innovation and Jobs Act (S. 866); and the Build it in America Act (H.R. 3938). However, these bills are not high priorities for the current legislative session, which leaves A/E executives to reckon with the uncertainty and try their best to mitigate the cash flow impact on their firms.
David Sullivan, CPA and leader of PKF O’Connor Davies Architectural and Engineering practice, comments: “ACEC is doing a great job trying to raise awareness of the negative impact of this law change on the industry. Our policymakers must quickly understand this is not a timing issue; it is a five-year unintended tax increase on industries whose underlying services are focused on research and development. This tax law change threatens the future existence of many businesses in the technology, healthcare, manufacturing and engineering industry.”
A Variety of Uncertainties
Among the uncertainties will be the impact on stock valuations. All other things being equal, a greater effective tax burden on a business would negatively impact its value to shareholders, as it means less cash available for distribution. Theoretically, this cash-flow impact would gradually lessen during the next several years as amortization deductions from prior years overlap, so the impact of section 174 is better characterized as an acceleration of tax liability rather than an increase in effective taxes.
The impact on upcoming 2023 year-end valuations will be driven by the increased future tax payments created by the change in Section 174, discounted to their present value. An appraiser should consider the annual increase of future capitalized expenses and determine their tax implication. Furthermore, with no legislation resolutions in sight, many firms will already have paid unexpectedly large tax bills. The resulting reduction in cash balances (or increased debt) will also cause a direct reduction in equity value.
Regarding the marketplace for A/E firms, we have yet to observe any material impact on valuation multiples of publicly traded firms or in private market transactions (mergers and acquisitions) from this change in the tax code. This is likely due to remaining uncertainty about whether or not the tax code may be amended and the ability of many firms to mitigate the impact
through various tax strategies.