This newsletter highlights some of the most recent federal and state tax updates in the month of March.
Federal Tax Updates
Continuation from the prior newsletter:
IRS update on reporting digital assets
On January 24, 2023, the IRS reminded taxpayers that they must answer a digital asset question and report all digital asset-related income when they file their 2022 federal income tax return. For more information and continued updates on digital asset reporting, please click on the link here.
IRS updates factsheet on Tax Credits for Electric Vehicles
National Taxpayer Advocate delivers 2022 Annual Report
The Advocate’s report to Congress assessed taxpayer service during 2022. It identified the ten most serious problems taxpayers were experiencing in their dealings with the IRS and made recommendations to address those problems. This year’s report outlined specific initiatives for the IRS to include in its plan how the additional funding it received in the Inflation Reduction Act will be spent. The report designed to help the IRS improve its online operations.
The taxpayer advocate reviewed the IRS website along with the website of 41 states which have an individual income tax, the District of Columbia, Puerto Rico, and three Countries, Canada, Australia, and the United Kingdom. It identified three areas where the IRS website lagged behind those of the other taxing authorities and suggested possible improvements.
Research and Development Tax Credit
Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), research and experimental (R&E) expenses changed Section 174 of the Internal Revenue Code. As a result of this change, taxpayers are now required to capitalize Section 174 R&E expenditures incurred after 12/31/2021 and amortize them over 5 years. (Qualifying foreign expenditures are required to be amortized over 15 years).
Section 174 R&E expenses can be broken down into two categories. The first category, direct research expenses, are items that qualify for the R&D tax credit under IRC Section 41 such as wages, supplies, and materials. The second category, indirect research expenses, are those items that are incidental to the research being done such as rent, utilities, and travel. Apart from the rare exception, most Section 41 expenses are Section 174 expenses.
Many businesses have R&E costs that will be subject to the new capitalization requirements. In addition to the costs to develop a new product, costs necessary for the improvement of a product fall under this new rule. Additionally, costs related to the discovery of information subsequently used to develop or improve a product should be capitalized.
Effects for 2022:
Normally, a change from expensing costs to capitalizing and amortizing costs would require a taxpayer to file Form 3115, Application for Change in Accounting Method. To make the transition to this new method (somewhat) less complicated, the IRS issued Revenue Procedure 2023-11 which outlines simplified filing procedures for businesses adopting this new law. Taxpayers can file a statement with their original return, for the first tax year beginning after December 31, 2021, which includes a few key pieces of information and avoid filing a complicated Form 3115. However, the simplified filing procedures are not allowed for businesses who delay adoption of Section 174 capitalization.
This change in the treatment of R&E expenses will come as a surprise to many businesses. The timing issues resulting from the capitalization and amortization of expenses, rather than the immediate deduction of them, could result in higher tax liabilities in the short term. This could also cause cash flow issues for some businesses.
What can be done to mitigate the tax impact?
The Section 174 capitalization requirement could be repealed, or its enactment could be delayed. Businesses should consider filing extensions for the 2022 tax year to see if changes are forthcoming.
The new law is complex and nuanced. If you think your business will be affected, please contact your tax advisor.
Tax-exempt status for non-profit
Three Years Can Go By Quickly – Don’t Lose Your Tax-Exempt Status
Tax-exempt organizations faced too many obstacles as a result of the pandemic – widespread impact to mission activities, inability to hold in-person conferences, and to continue good works for the public and/or member organizations, and so much more. In many cases, organizations also had to quickly pivot from having staff members in office to having them to work remotely. These changes impacted both the field and back-office operations.
As we all make our way back to the office or settle into the “new” normal, many organizations are finding themselves in an unfortunate position of not having filed 990s during the pandemic. This could potentially result in the organization’s loss of its tax-exempt status. Regrettably, the IRS has not provided any of the penalty relief provisions for late filed 990s which it extended to other forms and filing entities in the fall of 2022. To complicate the issue, if the IRS has sent correspondence to an organization that no longer receives mail at their former address or they could not timely access the mail, the tax-exempt organization could be unaware of this unlucky predicament.
Organizations that do not file for three consecutive years automatically lose their tax-exempt status. The revocation is effective on the original filing due date of the third annual return or notice. If an organization’s tax-exempt status is automatically revoked, it is no longer exempt from federal income tax. An automatically revoked organization is not eligible to receive tax-deductible contributions and will be removed from the cumulative list of tax-exempt organizations, Publication 78. State and local laws may affect an organization that loses its tax-exempt status as well. The law prohibits the IRS from undoing a proper automatic revocation and does not provide for an appeal process. An automatically revoked organization must apply to have its status reinstated, even if the organization was not originally required to file an application for exemption.
The IRS publishes the list of organizations whose tax-exempt status was automatically revoked of failure to file a required Form 990, 990-EZ, 990-PF or Form 990-N (e-Postcard) for three consecutive years. IRS updates the list monthly. Check to make sure your organization is in good standing and has not been automatically revoked: https://apps.irs.gov/app/eos/.