Uncertainty surrounds treatment of section 174 expenses

The only bit of communication that has provided guidance from the IRS is Revenue Procedure 2023-8, which confirmed that although this would be considered an accounting method change, a form 3115 would not be required. A statement will be required to provide information regarding the amount and types of costs being capitalized to report the method change with 2022 tax filings, but compared to other method changes, this will not be an administrative burden. The IRS does note, however, if the statement is missed, a form 3115 would be required in future years to adopt the method change. With this in mind, tech companies should consult their tax advisors regarding their possible R&E expenditures before the final filing deadlines.

For many of our clients, I have suggested that they hold off filing their returns until the last minute to avoid the need to amend returns if state and local governments change their minds on this law. Most recently, New Jersey retroactively allowed for the expensing of R&E for certain companies performing their activities in New Jersey. While most states have not decoupled from the treatment, this is worth monitoring up until returns are filed.

While it sounds straightforward, without significant regulations to guide taxpayers, the answer is still very unclear. The Research and Development Credit in IRC Code Section 41(d)(1)(A) now references that in order to be eligible for the credit, the cost must be “treated as specified research and experimental expenditures under section 174.” This means the calculation of your R&E expenditures starts with any credit-eligible wages, supplies, or contractor costs. After that, older regulations and revenue procedures, such as IRC Regulation 174-4, indicate that a number of overhead items including depreciation, utilities and payroll taxes require inclusion. A code section like 263A has voluminous regulations to answer very similar questions, so it is not surprising to see the IRS is not rushing to finalize this guidance.

With some uncertainty about what constitutes a “Section 174 research and experimental expense,” businesses are left to rely on older guidance leaving some ambiguity about which expenses must be capitalized, and which can still be expensed. Some examples of Section 174 expenses are:

• Salaries and wages of employees engaged in research and experimental activities
• Cost of materials and supplies used in research and experimental activities
• Depreciation of equipment used in research and experimental activities
• Rent and utilities for facilities used in research and experimental activities
• Cost of testing and evaluating products or processes
• Cost of obtaining patents or copyrights
• Cost of consulting fees paid to experts in research and experimental activities

It is important to note that not all expenses incurred in connection with research and experimental activities are considered Section 174 expenses. The expenses must be incurred in connection with activities that are intended to discover information that would eliminate uncertainty concerning the development or improvement of a product, process, software, technique, formula, or invention.

For example, the cost of marketing a new product would not be considered a Section 174 expense, as it is not an activity that is intended to discover information. However, the cost of conducting market research to determine the feasibility of a new product would be considered a Section 174 expense.

If you are unsure whether an expense is a Section 174 expense, consult with your tax advisor.

Many U.S. companies utilize foreign affiliates to perform R&E functions. In a case where a foreign subsidiary is performing R&E functions on behalf of its U.S. parent, or the other way around, which company is incurring R&E expenditures requiring capitalization? Without the certainty of regulations, practitioners have relied on the concept of funded research, detailed in IRC Regulation 1.41-4A to identify the proper entity that will be required to capitalize the costs. For this reason, it’s essential to understand the true owner of your intellectual property, which party has the risk of loss, and where the research is being performed to plan accordingly.

As the final deadlines for the 2022 tax filing season approaches, a last-minute reprieve from these rule changes has become extremely unlikely. In June, the Build It in America Act was introduced and included retroactive changes to repeal the changes, so support still remains for a change, but given the timing, we’ll likely look to the next tax season for any changes.