IRS releases updated guidance re: accounting method changes for Section 174 research and experimental expenditures

The Tax Cuts and Jobs Act of 2017 contained a major change to taxpayers’ ability to deduct research and experimental expenditures under Section 174 of the Internal Revenue Code. Prior to the change, taxpayers were able to choose between deducting all research expenditures in the year paid or incurred or amortizing the costs over a period of no less than 60 months. Beginning January 1, 2022, taxpayers lost the ability to deduct the expenditures in the year paid or incurred. Updated Section 174 requires taxpayers to amortize research and experimental expenditures over either 5 years for domestic research, and experimentation or 15 years for foreign R&E expenditures. Amortization begins at the mid-point the year the cost is paid or incurred.

For many taxpayers, amortizing research and experimental expenditures will be a departure from past practice, likely requiring the filing of a change in accounting method. The IRS recently issued Rev. Proc. 2023-8 (modifying Rev. Proc. 2022-14), providing guidance around how to obtain automatic consent to make the necessary accounting method change. The designated automatic change number for this method change is “265.”

While it is normally necessary to file a Form 3115 to request an accounting method change, for purposes of the Section 174 change, the IRS is temporarily permitting a statement to be filed with the taxpayer’s income tax return in lieu of the Form 3115. The statement-in-lieu of Form 3115 is only available for the taxpayer’s first taxable year beginning after December 31, 2021. The statement must include the following information:

• The name and employer identification number or social security number, as applicable, of the applicant that has paid or incurred specified research and experimental expenditures after December 31, 2021;
• The beginning and ending dates of the first taxable year in which the change to the required Section 174 method takes effect for the applicant (year of change);
• The designated automatic accounting method change number for this change (see section 7.02(8) of this revenue procedure);
• A description of the type of expenditures included as specified research or experimental expenditures;
• The amount of specified research or experimental expenditures paid or incurred by the applicant during the year of change; and
• A declaration that the applicant is changing the method of accounting for specified research or experimental expenditures to capitalize such expenditures to a specified research or experimental capital account and amortize such amount over either a 5-year period for domestic research or 15-year period for foreign research (as applicable) beginning with the mid-point of the taxable year in which such expenditures are paid or incurred in accordance with the method permitted under Section 174 for the year of change. Also, the declaration must state that the applicant is making the change on a cut-off basis.

If the accounting method change is made in a year later than the first taxable year beginning after December 31, 2021, it will be necessary to file a Form 3115 with a modified 481(a) adjustment (taking into account only specified research or experimental expenditures paid or incurred in taxable years beginning after December 31, 2021). The following information must be attached to the Form 3115:

• A description of the type of expenditures included as specified research or experimental expenditures;
• The taxable year(s) in which the specified research or experimental expenditures subject to the change were paid or incurred by the applicant: and
• A declaration that the applicant has changed its method of accounting for specified research or experimental expenditures to capitalize such expenditures to a specified research or experimental capital account, and amortize such amount over either a 5-year period for domestic research or 15-year period for foreign research (as applicable) beginning with the mid-point of the taxable year in which such expenditures are paid or incurred in accordance with the method permitted under Section 174 for the year of change. Also, the declaration must state that the applicant is making the change with a modified Section 481(a) adjustment that takes into account only specified research or experimental expenditures paid or incurred in a taxable year beginning after December 31, 2021.

A transition rule provides that a taxpayer who filed a Federal tax return on or before January 9, 2023, for a taxable year beginning after December 31, 2021, is deemed to have complied with the accounting method change procedures to change its method of accounting for specified research or experimental expenditures paid or incurred in the first taxable year beginning after December 31, 2021, to the required Section 174 method to comply with Section 174 if the taxpayer:

• Reported the amount of specified research or experimental expenditures paid or incurred for such taxable year on Part VI of Form 4562, Depreciation and Amortization, filed with the Federal tax return and
• Properly capitalized and amortized such specified research or experimental expenditures in accordance with the required Section 174 method for such taxable year.

While previous guidance contained in section 8.01 of Rev. Proc. 2015-13 provided that the IRS would not require a taxpayer making an accounting method change under 2015-13 to change its method of accounting for the same item for a taxable year prior to the requested year of change, Rev. Proc. 2023-8 does not provide such audit protection. Section 3.02(7) provides that filing an accounting method change under the procedures noted above does not provide a taxpayer with audit protection for expenditures paid or incurred in taxable years prior to the first taxable year in which Section 174 becomes effective.

Our team will continue to monitor further legislative updates in this area. Please contact your Elliott Davis tax advisor with any questions related to this guidance.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.