Guidance at last – IRS releases Section 174 accounting method guidance
On Dec. 12, the IRS released Revenue Procedure (Rev. Proc.) 2023-8, which modifies Rev. Proc. 2022-14 to provide procedures to change methods of accounting for specified research or experimental expenditures to comply with IRC Section 174 as amended by the Tax Cuts and Jobs Act (TCJA) of 2017.
This Revenue Procedure comes at a time when many taxpayers and professionals are waiting to get an answer on whether this rule from the TCJA will be extended. As of this article, talks continue between both political parties, and hopes of advancing legislation that would bring the two sides together on tax matters that include the extension of the requirement to capitalize Section 174 costs are described as “lukewarm.” If no agreement is reached, the information outlined in the Revenue Procedure and summarized below will need to be considered for taxpayers and their 2022 tax returns.
The former IRC Section 174(a) permitted taxpayers to deduct research and experimental expenditures in the year paid or incurred, or taxpayers could elect under Section 174(b) to treat specified research and experimental expenditures as deferred expenses and deduct them ratably over a period of not less than five years, beginning with the month in which the taxpayer first recognized the benefit of the expenses.
The TCJA amended Section 174 to require taxpayers to capitalize costs properly identified as research and experimental expenditures and amortize such costs ratably over a period of either five or fifteen years (beginning with the midpoint of the tax year in which the specified expenditures are paid or incurred), depending on whether the costs were associated with domestic or foreign activity, respectively. (For some taxpayers, the exercise to break out costs between domestic and foreign Section 174 expenditures could be time-consuming and burdensome, so attention to these specific regulations should begin as soon as possible.) The TCJA specified that amendments to Section 174 were applicable to research and experimental costs incurred in taxable years beginning after Dec. 31, 2021. Finally, based on the language and definition for qualifying expenditures in Section 59(e)(2), the election to amortize qualifying expenditures wouldn’t be available after Dec. 31, 2021.
Section 2.02(7) of the new Rev. Proc. 2023-8 provides that the application of the amendments made by the TCJA to IRC Section 174 “shall be treated as a change in method of accounting for purposes of Section 481 and that 1) such change shall be treated as initiated by the taxpayer, 2) such change shall be treated as made with the consent of the Secretary, and 3) such change shall be applied only on a cut-off basis for any research and experimental expenditures paid or incurred in taxable years beginning after Dec. 31, 2021, and as no adjustments under Section 481(a) shall be made.” (Emphasis added.)
For a taxpayer’s first taxable year beginning after Dec. 31, 2021, the requirements to file a Form 3115 and a duplicate copy of Form 3115 under Section 6.03(1)(a) of Rev. Proc. 2015-13 are waived. Instead, under Section 3.02(4)(a)(ii) of Rev. Proc. 2023-8, taxpayers may file a statement in lieu of Form 3115. This statement must include several disclosures, all of which are found within the Revenue Procedure.
If the taxpayer is changing its method of accounting for Section 174 expenditures in a year later than the first taxable year beginning after Dec. 31, 2021, Rev. Proc. 2023-8 provides that taxpayers must make the change using a modified Section 481(a) adjustment that considers “only specified research or experimental expenditures paid or incurred in taxable years beginning after Dec. 31, 2021.” A statement must also be included with Form 3115 with specific items that are provided within the Revenue Procedure.
Taxpayers who filed a federal tax return on or before Jan. 9, 2023, for a taxable year beginning after Dec. 31, 2021, are deemed to have complied with the Section 446 method change procedures of Section 7.02 of Rev. Proc. 2022-14, as modified by Section 3 of Rev. Proc. 2023-8, provided that the taxpayer 1) reported the amount of specified research and experimental expenditures paid or incurred for the tax year on Part VI of Form 4562, and 2) properly capitalized and amortized the specified research and experimental expenditures in accordance with the required Section 174 method for such taxable year. It is unclear at this time if taxpayers who complied with the rules but didn’t report the information on the Form 4562 would invalidate their ability to use this transition rule outlined in Rev. Proc. 2023-8.
Limited audit protection is provided for taxpayers changing their method of accounting under Section 7.02 of Rev. Proc. 2022-14, as modified by Section 3 of Rev. Proc. 2023-8. Specifically, Rev. Proc. 2023-8, Section 3.02(7), states that no audit protection is provided for research and experimental expenditures incurred in taxable years beginning before Jan. 1, 2022. For taxable years beginning after Dec. 31, 2021, even after the taxpayer files the required statement or Form 3115, the IRS could change the taxpayer’s characterization of costs as Section 174 costs in order to more properly reflect the amount of Section 174 expenditures paid or incurred for such taxable year.
What does CohnReznick think?
While the procedural guidance is helpful, taxpayers will still need substantive rules telling them exactly which costs must be capitalized. Specifically, it seems that based on existing case law and interpretations of the definitions included in Section 174 and Treas. Reg. 1.174-2, Section 174 costs will include a wider range of costs than those included in the definition of Qualified Research Expenditures for purposes of the R&D tax credit. However, at this moment, taxpayers cannot know exactly which costs should be capitalized. For example, to what extent will the IRS require taxpayers to capitalize overhead costs to their R&D function and to treat those overhead costs as Section 174 costs? Also, there could be more immediate impact for taxpayers that have already filed short-year tax returns beginning and ending in 2022. Taxpayers should consult their tax advisors to review their facts and determine their best course of action.
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