The new Section 174 law – which went into effect for taxable years beginning after Dec. 31, 2021 – was enacted as part of the Tax Cut and Jobs Act and has far-reaching implications for any company that has qualified research expenditures for purposes of the R&D tax credit as well as those with any costs appropriately categorized as Section 174 expenses under the revised code and regulations.
Key concerns to keep in mind include:
- Costs historically expensed must be capitalized this year and amortized over five and/or 15 years
- This change potentially impacts all taxpayers (e.g., a company with a loss)
- Relevant costs include software development, portion of indirect costs such as utilities, lab materials, attorney fees, depreciation, rent, computer supplies, repairs, and maintenance, etc., as well as traditional R&D type costs
- A statement containing taxpayer-specific information is required to be attached to the return to preserve the taxpayer’s rights
- Some states have decoupled from this new rule (e.g., California)
Legislative Outlook (Updated June 27, 2023)
A recently introduced House bill (H.R. 3938 – Build It in America Act) included a patch to Section 174 that would allow taxpayers to immediately deduct research expenses incurred through Dec. 31, 2025. The bill has yet to receive House approval and would have a difficult time passing a Senate vote without modifications or negotiations. Although taxpayers can take some solace that an update to Section 174 seemingly has bipartisan support, any legislative action that would effectuate the change continues to be a challenge. Additionally, as taxpayers prepare for extended tax return filings this fall, it’s becoming less likely that a fix will be in place before those returns are due. Even with draft legislation being considered, taxpayers must continue to apply the current law requiring amortization of research expenditures.
Section 174: Considerations heading into tax return season
Section 41 / R&D Credit Refresher: Internal Revenue Code (IRC) Section 41 governs the rules around the application of the Credit for Increasing Research Activities (R&D credit). It provides that expenses must meet four requirements (i.e., the four-part test) to be considered qualified research expenditures (QRE or “Section 41 costs”). It should be noted that only domestic expenditures qualify for the R&D Credit under § 41. The four-part test includes:
1. Qualified purpose (Treas. Reg. § 1.41-4(a)(5)(ii)). Expenditures must relate to a new or improved function, performance, reliability, or quality of a business component.
2. Process of experimentation (Treas. Reg. § 1.41-4(a)(5)(i)). Expenditures must be incurred as part of a process of experimentation designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer's research activities.
3. Technological in nature (Treas. Reg. § 1.41-4(a)(4)). Expenditures are technological in nature if the process of experimentation relies on the physical or biological sciences, engineering, or computer sciences.
4. Elimination of uncertainty (Treas. Reg. § 1.41-4(a)(3)(i)). Expenditures must be incurred for research that is undertaken for the purpose of discovering information intended to eliminate uncertainty concerning the development or improvement of a business component (e.g., a product or process).
Differences between Section 41 & Section 174: QREs under Section 41 are also considered Section 174 expenditures. However, Section 174 includes a much broader range of expenses than Section 41. For example:
1. Foreign v. Domestic: Section 41 is limited to domestic expenditures, whereas Section 174 includes both foreign and domestic costs.
2. Indirect Costs: Section 41 costs are limited to salaries and wages, supplies, and contract research. Section 174 costs include a much broader base of expenses, including software development costs and those costs that are “incident to the development or improvement of a product or process.” (Treas. Reg. § 1.174-2(a)(1) and Treas. Reg. § 1.174-2(a)(11), Example 10). There has been IRS guidance over the years indicating that section 174 expenses include allocable overhead costs. One example in Treas. Reg. § 1.174-4(c) included utilities, lab materials, attorney fees, and depreciation in Section 174 costs. Other Section 174 costs could include rent, computer supplies, repairs, and maintenance, etc.
3. Loss Companies: Generally, the R&D credit is not applicable to companies with tax losses in the current year or with loss carryforwards. Taxpayers in that position may, however, wish to calculate the credit for carryforward purposes. The change to Section 174 is applicable to all companies, regardless of whether they are in an income or loss position, and regardless of whether they take the R&D Credit. As such, the requirement to identify, disclose, and amortize Section 174 expenses is not optional.
State Conformity: Companies should review each state in which they have a filing obligation to determine if it has conformed to the Section 174 law change enacted by the Tax Cut and Jobs Act in 2018.
Required Disclosure/Statement: A statement pursuant to Revenue Procedure 2023-11 is required to be attached to the return for any taxpayer that has Section 174 costs.
What does CohnReznick think?The requirement within Section 174 to capitalize specified research or experimental expenditures instead of immediately expensing these items impacts a wide range of other calculations that companies must perform for tax return compliance purposes. Identifying and appropriately reporting Section 174 costs can be burdensome and time-consuming. Taxpayers should consult their tax advisors to review their facts and determine their best course of action.
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