Requirements for amortization of research and experimental expenses under Internal Revenue Code Section 174

Internal Revenue Code Section 174 covers the tax treatment of a taxpayer’s research and experimental expenditures[1]. 

For taxable years beginning prior to January 1, 2022, § 174(a) taxpayers had the option either to currently deduct research and experimental (“R&E”) (also referred to as research and development or “R&D”) expenditures (the “current expense” method)[2] or to defer and amortize the expenditures over a period of not less than 60 months (the “deferred expense” method)[3].  Additionally, a taxpayer was also permitted to elect to defer the expenditures under § 59(e), which provided a 10-year amortization period.

For taxable years beginning after December 31, 2021, § 174(a) taxpayers only have the option to amortize R&E expenditures over 5 years in the case of domestic R&E spend or 15 years for foreign R&E spend.  The amortization begins at the midpoint of the year in which the expenditures are paid or incurred[4].

In order to comply with § 174, taxpayers need to determine whether they are engaging in activities that should get amortized[5]— such as expenditures directly related to developing new products, improving existing products (See Appendix A), or indirect research expense—as opposed to the narrower range of research expenses under § 41— credit for increasing research activities.  

As some expenditures can overlap and qualify for both the § 174 deduction and the § 41 credit, taxpayers must either make a reduced credit election under § 280C or add back all § 41 credit eligible expenses on the applicable tax return.

For taxpayers currently deducting § 174 expenditures, the change to mandatory amortization will be a departure from past practice, likely requiring the filing of a change in accounting method.  However, on December 12, 2022, the IRS released Rev. Proc. 2023-8 (modifying Rev. Proc. 2022-14), providing guidance around how to obtain automatic consent to make the necessary accounting method change. 

Rev. Proc. 2023-8 highlights the following:

• Grant of automatic consent – Taxpayers may use this new automatic accounting method change procedure to secure the IRS consent required to change from their present § 174 accounting method.

• Statement in lieu of Form 3115 for changes made in the first effective year – The IRS is temporarily permitting a statement to get filed with the taxpayer’s income tax return in lieu of Form 3115 for changes made in the first taxable year beginning after December 31, 2021.

• Changes after first taxable year and modified § 481(a) adjustment – It will be necessary to file Form 3115 with a modified § 481(a) adjustment if the accounting method changes are made later than the first taxable year beginning after December 31, 2021 (considering only specified R&E expenditures paid or incurred in taxable years beginning after December 31, 2021).

• Transition rule – The transition rule provides that a taxpayer that 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 and transition to the required §174 method for specified R&E expenditures paid or incurred in the first taxable year beginning after December 31, 2021 if the taxpayer:
  • (i) reported the amount of specified R&E expenditures paid or incurred for such taxable year on Part VI of Form 4562, Depreciation and Amortization; and
  • (ii) properly capitalized and amortized such specified R&E expenditures in accordance with the required §174 method for such taxable year.

• Waiver of eligibility rule – Prior guidance found in § 8.01 of Rev. Proc. 2015-13 provided that the IRS would not require taxpayers making an accounting method change under 2015-13 to change their method of accounting for the same item for a taxable year prior to the requested year of change.  Rev. Proc. 2023-8 does not grant such audit protection.  Moreover, § 3.02(7) provides that filing an accounting method changed 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 § 174 becomes effective.

APPENDIX A

Treas Reg. § 1.174-2(a) broadly discusses the principle of inclusion of costs incurred in, or incident to, research and experimentation.  Within the context of § 174, research and experimentation generally include all costs incident to the development or improvement of a product (i.e., expenditures in connection with a taxpayer’s trade or business that represent research and development costs in the experimental or laboratory sense).  Furthermore, the determination on whether a particular expenditure is “incident to” is based on the specific facts and circumstances.

The list below is not exhaustive but instead serves as examples of guidance on eligible expenditures.  For in-depth analysis, reach out to Elliott Davis, LLC:

• Depreciation on a workstation used by a software developer would be incident to research to develop a new software application.
• An allocable portion of a janitorial costs center which spends a portion of their time performing cleaning services at a laboratory also should be eligible for § 174 deductibility.
• Costs incurred to eliminate a taxpayer’s uncertainty associated with the capability, method, or appropriate design are costs in the laboratory or experimental sense.
• Costs of pilot models which are defined as any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product[6].
• Treas. Reg. § 1.174-2(b) allows for the deduction of certain costs when research conducted by a taxpayer creates depreciable property as the end product to be used in the taxpayer’s non-research or trade.  However, the eligible expenses for deduction must be connected with the development and construction of the depreciable property that is specifically attributable to the research or experimentation.
• Expenditures paid or incurred by a taxpayer for research and experimentation carried on in the taxpayer’s behalf by another person or organization are eligible for deduction[7].

A taxpayer may claim a § 174 deduction on expenditures made for research and experimentation in which the end product is depreciable property used in the taxpayer’s trade or business.  Furthermore, under Treas. Reg. § 1.174-2(b)(3) research and expenditures incurred in connection with construction or manufacture of depreciable property by another individual on the taxpayer’s behalf may be deductible in regards to costs where the depreciable property is produced upon the taxpayer’s order and at his risk.  Additionally, pursuant to Treas. Reg. § 1.174-2(b)(4) a taxpayer is permitted to allocate the overall cost of the property between the cost of research and the cost of construction with the research component being the only one of the two that are eligible for § 174 treatment.

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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.

[1] Except as otherwise expressly provided herein, all references to “section” are to sections of the Internal Revenue Code of 1986, as amended (the “Code), and all references to “Reg. §” or “Regulations” are to Treasury regulations issued pursuant to the Code.  Furthermore, all references to “IRS” or “Service” are to the Internal Revenue.

[2] Pre-2022 §174(a), prior to amendment by the TCJA, Pub. L. No. 115-97, §13206.

[3] Pre-2022 §174(b).

[4] §174(a)(2)(B).

[5] Treas. Reg. §1.174-2(a)(1).

[6] Treas. Reg. § 1.174-2(a)(4) and Rev. Rul. 73-275.

[7] Treas. Reg. § 1.174-2(a)(10) and Rev. Rul. 69-484.