IRS Adopts Final Regulations on Research and Experimental Expense Deductions
Taxpayers may now benefit from final regulations pertaining to Section 174 research and experimental costs associated with the development of tangible property. The final regulations keep many of the taxpayer-friendly provisions that were contained in the proposed regulations.
Generally, Section 174 allows a taxpayer to take a current deduction for research or experimental costs either as they are paid or incurred or to amortize these costs over a time period of 60 months or more. If it were not for the 174 rules, product research and development costs would generally need to be capitalized.
The IRS issued proposed regulations in late 2013 to clarify certain definitions and ease existing restrictions on research and experimental costs, such as limiting the scope of the "shrinking back" rule described in the last two points. Such changes included:
- If costs qualify as research or experimental costs, it will not matter if the resulting product is eventually used or sold in the taxpayer’s business. The success, failure, sale, or other use of the research or property resulting from the research is not relevant when determining if those costs qualify as deductible research costs.
- Costs related to the production of a product, after the elimination of uncertainty concerning the development or improvement of the product, do not qualify as deductible research costs.
- The depreciable property rule is treated as an application of the general definition of research expenditures to depreciable property and should not be applied to exclude costs that otherwise would qualify as deductible research costs.
- The term “pilot model” is defined in the proposed regulations as any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during its improvement or development. The “pilot model” definition includes a fully functional representation or model of the product, or a component of the product, to the extent the “shrinking-back rule” provision applies.
- The “shrinking-back rule” applies to situations when research and experimental costs qualify as deductible research costs only for a component part of a larger product, as opposed to the overall product itself.
The final regulations keep much of the substance of the proposed regulations, with minor additions:
- Examples in the regulations are modified and added to demonstrate the application of the research and experimentation deduction to the components of a product.
- An example is modified to clarify that the costs of multiple pilot models may qualify as research and experimental expenditures without each pilot model being tested for a discrete purpose.
The final regulations apply to tax years ending on or after July 21, 2014, as well as tax years that have not closed, according to the limitations period.
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The final regulations clarify that, if expenditures otherwise qualify as research expenditures, it does not matter if the product resulting from the research is ultimately sold or used in a taxpayer’s trade or business. In addition, the final regulations eliminated references to the “shrink back rule” to eliminate any confusion with the shrink back rule contained in the regulations for the R&D Credit. Further, it should be noted that if expenditures qualify as research expenditures, they do not have to be capitalized under Section 263A.
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