Section 174 and Capitalization of R&D Costs

By Martin Gamez and Fernando Jimenez

One delayed tax impact of the 2017 Tax Cuts and Jobs Act (TCJA) went into effect as of January 1, 2022. Taxpayers may no longer take current deductions for research and experimental expenditures. For tax years beginning after December 31, 2021, the act mandates that taxpayer’s specified research and development expenditures must be charged to a capital account and amortized over five years beginning with the midpoint of the taxable year (6, with mid-year convention) in which the expenditures are paid or incurred. Expenditures attributable to foreign research must be amortized over 15 years.

Before the Tax Cuts and Jobs Act (TCJA), taxpayers could deduct research and experimental expenditures as paid or incurred. An election could also be made to amortize the expenditures over not less than 60 months. A third alternative allowed the expenditures to be amortized over ten years under §59(e).

In 2021, Representatives John Larson and Ron Estes introduced a bill to delay or undo amendments to section 174. To date, no legislation has been advanced. Therefore, taxpayers should continue to proceed as if this provision will be in effect for 2022 tax returns. 

Identifying §174 R&D Expenses 

Regardless of taxpayers’ selection of accounting method for Sec. 174 expenditures, for purposes of the R&D tax credit, Sec. 41(d) defines “qualified research” in part as “research with respect to which expenditures may be treated as expenses under section 174.” Currently, many taxpayers may claim expenditures for the R&D tax credit under Sec. 41 that they may deduct elsewhere on their tax return under Sec. 162, as an ordinary and necessary business expense.

IRC section 174 expenditures must be for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. Product is defined as any pilot model, process, formula, invention, technique, patent, or similar property. It includes products to be used by the taxpayer in its trade or business and products to be held for sale, lease, or license.

The appropriate costs to capitalize under §174 will be challenging for taxpayers who have not previously established a process for identifying and tracking these expenditures. Historically there was no difference between a current deduction under § 174 and a current deduction under § 162, as such taxpayers previously had little reason to categorize R&D costs under one code section or the other unless they elected to capitalize those costs under §59(e).

Although there has been no guidance outlining how to specifically identify expenditures under the broad definition of §174, taxpayers will need to make a reasonable effort to calculate the amount to capitalize and should document those efforts. The following should be considered:

• Review ASC 730 R&D expenses which should include all R&D cost centers and overhead costs. ASC 730 defines the terms “research” and “development” separately. Activities that are not covered by the definitions of research or development in ASC 730 would not qualify.
• If applicable, review the taxpayer’s current or prior year §41 R&D credit calculation. Expenditures included for §41 meet a more stringent set of tests than are required for §174, so §41 costs are likely the minimum amount to be included for §174.
• Review activities performed in cost centers outside R&D that may be R&D related.

Examples of costs specifically excluded from § 174 would be the following:

• Routine design of tools, jigs, molds, and dies
• Quality control during commercial production, including routine testing of products
• Costs related to acquiring or improving land or for the acquisition or improvement of property subject to depreciation or depletion under §§167 and 611, even if used in connection with R&E activities
• Seasonal or other periodic design changes to existing products
• Trouble-shooting in connection with break-downs during commercial production
• Research in social sciences, arts, literary or historical topics
• Adaptation of an existing capability to a particular requirement or customer’s need as part of a continuing commercial activity
• Acquisition of another’s patent, model, production or process
• Engineering follow-through in an early phase of commercial production

Once §174 expenditures have been identified, those expenditures must further be categorized as domestic vs. foreign to apply the appropriate 5- or 15-year amortization.

Accounting Method Change

On December 12, 2022, the IRS released procedures (Rev. Proc. 2023-8) for a taxpayer to automatically change their method(s) of accounting for research and experimentation (R&E) expenditures (including software development costs) paid or incurred in tax years beginning on or after January 1, 2022, to comply with the TCJA amendments to §174.

This automatic change will replace the form 3115 Application for Change in Accounting Method. This method change is made on a “cutoff” basis, meaning taxpayers implement the change with their first taxable year beginning after December 31, 2021, without any adjustment for expenditures incurred in previous years.

However, should a taxpayer fail to adopt the new method timely in year one, a method change in a subsequent year will require a modified §481(a) adjustment that takes into account R&E expenditures arising in taxable years beginning after December 31, 2021.

In lieu of Form 3115, taxpayers are permitted to file a statement with their tax return for their first tax year beginning after December 31, 2021. The IRS will treat such a statement as Form 3115 for purposes of the automatic method change procedures.

The statement must include the following:

1. Name and EIN/SSN of the applicant;
2. The beginning and end dates of the first taxable year in which the change in 174 method takes effect (year of change);
3. The designated automating accounting method change number for this change;
4. A description of the type of expenditures included as specified research or experimental expenditures;
5. The amount of specified R&E expenditures paid/incurred by the applicant during the year of change; and
6. A declaration that the applicant is changing the method of accounting for R&E expenditures to capital account and show both 5-year/15-year expenses.

If a change is made in a subsequent taxable year, then it must be made by filing a Form 3115 in duplicate, with the modified §481(a) adjustment by the due date of the tax return (including extensions) for the change year. The 3115 must include an attachment containing the following information for each applicant:

1. Name and EIN/SSN of the applicant;
2. The beginning and end dates of the first taxable year in which the change in 174 method takes effect (year of change);
3. The designated automating accounting method change number for this change;
4. A description of the type of expenditures included as specified research or experimental expenditures;
5. The amount of specified R&E expenditures paid/incurred by the applicant during the year of change; and
6. A declaration that the applicant is changing the method of accounting for R&E expenditures to capital account and show both 5-year/15-year expenses.

Terms and Conditions:

Unfortunately, the procedures provide very limited transition relief to comply with the TCJA amendments to §174. Key provisions are outlined as follows:

• As discussed above, no special transition rule is provided for a taxpayer that previously filed a nonautomatic method change application to implement amended §174.
• No audit protection is provided for §174 expenditures paid or incurred in tax years beginning prior to January 1, 2022 (prior to the TCJA amendment effective date), nor does Rev. Proc. 2023-8 impact the tax treatment or method changes related to such costs.
• Limited audit protection is provided for specified research or experimental expenditures covered by the new procedures (i.e., costs incurred in tax years beginning after December 31, 2021 that are subject to §174 as amended under the TCJA). Taxpayers will need to analyze and document all 174 expenditures for audit purposes.

If a company does not follow the automatic method change procedures for the first year beginning after December 31, 2021, the company will need to follow the method change rules described above.

How We Can Help

 Many taxpayers will have problems accounting for their §174 expenses which may not have been a factor in the past. This law change may bring up various questions and challenges. RJI CPA’s R&D professionals can assist your organization in identifying your §174 expenses and preparing necessary accounting method changes. This can also be done seamlessly as part of an R&D tax credit analysis. Contact RJI CPAs today to learn how we can help your organization comply with these new rules.