While deductions shrink, an overlooked strategy holds promise
Recent changes in federal tax law have not been kind to businesses in general, and retailers in particular. Among these recent changes, the sunsetting of deductions for bonus depreciation on certain capital expenditures, revisions to the treatment of research and experimentation (R&E) expenditures, and revisions to the computation of limitations on the deductibility of business interest expense, have required most retailers to take a hard look at their tax methods and elections. The impact of these changes has only been exacerbated by the recent rise in interest rates in response to inflation.
R&E expenditures: Taking a closer look
Previously, R&E expenditures could be deducted as an expense in the year in which they were incurred. Now, these costs must be capitalized and amortized over five years for domestic research and 15 years for foreign research. Further, software development costs, which previously were optionally treated as deductible, are now specifically capitalizable under IRC Section 174. For these R&E expenditures, the first-year deduction is a fraction of what it would be under the previous law (for example, by amortizing over five years with a mid-year convention, a taxpayer receives a 10% deduction in Year 1).
Given the broad scope of expenses that may be classified as R&E, the change to the rules may be more impactful for retailers than it may first appear. Many retailers may not think that they have R&E in their operations because they do not engage in new product development. But, in addition the new product development, R&E now also includes the costs of designing, modifying, or even customizing software. Retail software R&E expenses could include projects like website management, developing point-of-sale systems and customer portals, and implementing and customizing enterprise resource planning, warehouse, and fleet management systems.
Further, the costs properly associated with this development may be broader than expected. In addition to the qualified wages, supplies and contractor expenses included in R&D credit calculations, Section 174 costs include additional categories of indirect costs associated with R&E activities. Grant Thornton Corporate Tax Services Partner Joe Parrish noted, “If a retailer is currently taking an R&D credit, they should be very diligent in reviewing the costs that are being accumulated as qualified research expenditures, because (Section) 174 looks at those costs and expands the cone to the all indirect costs associated with those wages, supplies and contractors that fill in your qualified research expenses, such as employee benefits, facility costs.”
Business interest deduction limitations: Review and reclassify
The new Section 163(j) rules enacted with tax reform, effective for tax years beginning after Dec. 31, 2017, limited business interest deductions to 30% of a tax basis EBITDA. For years beginning after Dec. 31, 2021, that measurement changes to 30% of a tax basis EBIT. Not allowing companies to addback depreciation and amortization deductions in computing the interest expense limitation under Section 163(j) has resulted in significant limitations in deducting interest expense for many retailers. If businesses have relied heavily on bonus depreciation—and many retailers have—this change may hit them particularly hard.
The change from EBITDA to EBIT has reduced the amount of interest expense that is currently deductible by companies and forces them to carry it forward to use in a future year. Because the annual limitation will continue to be 30% of EBIT, many companies are projecting that it is unlikely that the carryforwards will be used anytime soon, instead causing a seemingly perpetual disallowance. At the same time, interest rates continue to rise in response to inflation, which worsens the issue in those future years as the gross interest expense increases.
Fortunately, there are both simple and complex ways to address the issues this limitation poses. The simple fix starts by making sure that interest expense is accurately reflected – not all items including in the “interest” category for book purposes are necessarily “interest” for tax purposes, and therefore may not be limited. Companies may also increase taxable income – and EBIT – by making certain annual elections, including “turning off” bonus depreciation. However, increasing taxable income in order to deduct 30% of the increased amount as interest expense has obvious drawbacks.
The more complex, but ultimately more promising, considerations include utilizing cost capitalization provisions and associated elections and/or methods to characterize business interest as a capitalizable component of an asset. Under this approach, the capitalized interest would then be recovered following the method of cost recovery for that item (e.g., depreciation or cost of goods sold). In essence, the more complex cost accounting approach recharacterizes the interest expense to the basis of another item, so that it is no longer interest for tax purposes.
Cost segregation: Dust off the playbook
In prior years, many of the negative impacts described above might have been mitigated by 100% bonus depreciation on many depreciable assets acquired for use by retail companies, like new equipment or shelving, as well as remodel projects to both leased and owned stores. The bonus depreciation rules originally enacted to encourage capital outlays after 9/11 and was recently modified by the Tax Cuts and Jobs Act (TCJA). Beginning in 2023, the bonus depreciation rate will be reduced to 80% and continue to decrease 20% each year until it phases out completely in 2027. As currently enacted, bonus depreciation will provide a lower offset to the higher taxable income that results from changes to R&E deductions and interest expense limitations beginning in 2023.
A fixed asset analysis, leading with cost segregation, on the other hand, may be a way to offset higher-than-expected taxable income The goal of the fixed asset analysis would be to find opportunities to accelerate the recovery period or deduct expenses related to fixed assets where possible. This strategy is not new, but it has been overlooked in recent years when most of the expenditures were eligible for 100% bonus depreciation.
Grant Thornton Corporate Tax Services Partner Michael Sinese outlined the process: “You start with documentation. If you have contemporaneous documentation from contractors, you can bifurcate certain costs related to buildings into a shorter prescribed IRS depreciable life on certain assets. And to the extent that you don't have contemporaneous documentation, you may use construction drawings and valuation techniques...”
Cost segregation may have special relevance in the post-pandemic retail world. Grant Thornton Retail National Managing Partner Kevin Kelly notes that “We've seen a resurgence of stores and the benefit of having a true omnichannel strategy. We've seen digitally native retailers begin to open up stores, and as they too go into the store build-out landscape, combined with the phase-out of bonus, taking a closer look at cost segregation for those build-outs could be very beneficial.”
These three combined changes can make a significant impact on retailers beginning in 2023 and into the future. In fact, these three specific provisions have prompted a vigorous lobbying effort. Many businesses had hoped that they would be repealed or deferred by Congress—there is bipartisan support for doing so with respect to R&D expenditures—but that now appears unlikely, as evidenced by the lack of legislative action in time to impact taxpayers 2022 tax returns. Fortunately, with careful planning, taxpayers still have options that can help offset the recent changes in federal tax law.
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