^{Portions of this article were originally published in Forbes}

On Sept. 8, the IRS released Notice 2023-63 (Notice), providing additional guidance in connection with the amortization of Specified Research or Experimental (SRE) expenditures under IRC Section 174, as amended by the Tax Cuts and Jobs Act. The Notice states that the provisions contained in Sections 3 through 9 are applicable for taxable years ending after Sept. 8, 2023. Noteworthy portions of the Notice are highlighted below.

R&D department costs

Section 4.03(1) of the Notice clarifies that labor costs – including those for contract employees and independent contractors – related to those who perform, supervise, or directly support SRE activities are considered Section 174 expenditures. All elements of compensation are to be included with the exception of severance, which is excludable and deducted by taxpayers in the period paid or incurred. SRE-related labor costs expenses included in the Notice expenses related to pension costs and stock-based compensation.

Section 4.03(1)(e) provides guidance pertaining to certain costs related to operation and management (i.e., rent, utilities, etc.) activities. Specifically, in addition to items such as rent, utilities, and insurance, expenditures such as taxes (i.e., property), repairs and maintenance, and security are now considered SREs subject to Section 174.

How should businesses react? The IRS has taken the position that the full costs of the R&D department, not simply gross wages collected for purposes of the Research and Development Credit under IRC Section 41, now need to be identified and capitalized. Unlike some other code sections, the IRS does not prescribe any specific methodology by which these costs need to be identified and segregated from the general costs of the company though. This provides taxpayers with the flexibility to analyze these costs and determine the most tax efficient method by which to identify the costs. When defending a position with the IRS, documentation and consistency is the key. So, in addition to identifying these costs for tax purposes, adding general ledger accounts and creating separate internal accounting policies to track these costs on your financial statements will provide the most transparency for company management and allow for very simple tax reporting.

Software development

Section 5.03 of the Notice provides guidance on what constitutes software development for purposes of Section 174. Though the list is not exhaustive, it includes:

• Planning the development of the computer software (or the upgrades and enhancements to such software)
• Designing the computer software (or the upgrades or enhancements to such software)
• Building a model of the computer software (or the upgrades or enhancements to such software)
• Writing source code and converting it to machine-readable code
• Testing the computer software (or the upgrades or enhancements to such software) and making necessary modifications to address defects identified during testing, but only up until certain events occur (depending on whether the software is developed for use in the taxpayer’s trade or business or for sale or licensing to others)
• Production of the product master(s) if the computer software is developed for sale or licensing to others

Sections 5.04 and 5.05 highlight the following activities not considered to be Section 174 costs related to software developed for use in a taxpayer’s trade or business and software developed for sale or licensing to others:

• Training of employees in the use of the software
• Maintenance activities after the software is placed into service that do not constitute upgrades or enhancements (i.e., corrective maintenance to debug, diagnose, and fix programming errors)
• Data conversion activities (except activities to develop computer software that facilitates access to existing data or data conversion)
• Installation and other activities related to placing the software into service
• Marketing and promotional activities
• Distribution activities
• Customer support

How should businesses react? Even if employees are members of the R&D department, this does not mean 100% of their activities (and related salaries) should automatically be considered SREs which must be capitalized. This means companies should re-evaluate time tracking systems which allow for job codes that align with the definitions provided by the IRS. There is uncertainty around what kind of documentation the IRS will accept upon challenge due to how new these laws are, so the more contemporaneous and specific the documentation is, the better.

Research performed under contract

Section 6 of the Notice provides guidance for taxpayers to determine whether costs paid or incurred for research performed under contract are expenditures subject to capitalization under Section 174. The Notice provides in Section 6.04 that if a research provider incurs a risk that it may suffer a financial loss related to the failure of the research to produce the desired SRE product, then costs paid or incurred by the research provider that are related to the SRE activities performed under the contract are SRE expenditures and subject to Section 174. The Notice further states, however, that even if the research provider does not have financial risk related to the research product, if it has “a right to use any resulting SRE product in the trade or business of the research provider or otherwise exploit any resulting SRE product through sale, lease, or license,” then the costs incurred by the research provider in connection with the SRE product are deemed to be SRE expenditures and subject to the capitalization and amortization rules under Section 174. In other words, the right to use the product or research by the research provider results in the expenditures being subject to Section 174 even if there is no financial risk to the provider. Section 6.05 of the Notice provides an example of a research provider that has neither financial risk or rights to use the SRE product.

How should businesses react? Businesses should review both their third-party contracts, as well as their intercompany contracts, to ensure they are not ending up with an unfavorable result under Section 174 if there is not a business purpose for the terms in the contract.  Based on the rules above, situations can occur under which multiple parties are required to capitalize SREs relating to the same product which would be a bad result for any intercompany transaction or arrangement that can be controlled or altered.

Now that the IRS has published the Notice, it behooves taxpayers to review various aspects of their R&D function, including general ledger accounting, timekeeping, and contracts, to ensure they are being as tax efficient as possible. While these new rules provide clarity, they do not make tax reporting for businesses any simpler. The right adjustments and documentation could lead to a much better tax outcome and a smooth process heading into 2023 tax filings. 

Disposing of, retiring, or abandoning property

Section 7 reaffirms that, if a taxpayer disposes of, retires, or abandons any property with respect to which SRE expenditures are paid or incurred, no deduction is allowed with respect to the unamortized portion of the SRE expenditures. This is consistent with prior guidance related to Section 174 expenditures.

Long-term contracts under Section 460

Section 8 provides clarifying guidance related to long-term contracts under Section 460. Proposed regulations are expected to be forthcoming that would amend the existing Section 460 regulations to provide that costs allocable to a long-term contract accounted for using the PCM would include the amortization of SRE expenditures under Section 174 rather than the capitalized amount of those expenditures. The amortization of the SRE expenditures would be treated as incurred for purposes of determining the percentage of contract completion as deducted. The Notice does not contain a rule providing for how much SRE expenditures are included in the denominator of the completion factor under Section 460.

Additional guidance

The Notice mentions two additional pieces of guidance that are anticipated to be forthcoming. First, the Treasury and IRS intend to provide procedures for taxpayers to obtain automatic consent to change its method of accounting to comply with the Notice. Second, updated procedures are anticipated to address situations in which taxpayers have, prior to the issuance of the Notice, changed methods of accounting to comply with Section 174, as amended by the TCJA, but whose treatment of SRE expenditures is not entirely consistent with the Notice.