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Changes to the treatment of research expenditures under IRC Section 174 that recently took effect could increase taxable income for many companies. Among the businesses most likely to be affected are those in the manufacturing and technology sectors (particularly if they have internally developed software and SaaS business models).

For tax years beginning after December 31, 2021, taxpayers will no longer have the option to deduct research or experimental (R&E) expenditures but will be required to capitalize and amortize them. Many taxpayers hoped that Congress would delay the effective date of this change, but, with the Build Back Better Act on hold, the changes took effect as scheduled.

Background

In 2017, the Tax Cuts and Jobs Act (TCJA) amended Section 174 to require taxpayers to capitalize and amortize R&E expenditures for tax years beginning after December 31, 2021. The changes require taxpayers to amortize domestic expenditures over five years and foreign expenditures over 15 years, with amortization for both beginning with the midpoint of the taxable year in which the expenditure is paid or incurred.

In the case of retired, abandoned, or disposed property with respect to which specified R&E expenditures are paid or incurred, any remaining basis may not be recovered in the year of retirement, abandonment, or disposal, but instead must continue to be amortized over the remaining amortization period. Prior to the TCJA, taxpayers could choose to either deduct Section 174 expenses, capitalize the expenditures and amortize them over five years, or elect a 10-year amortization of expenditures under IRC Section 59(e).

The TCJA also changed the term “research or experimental expenditures” in Section 174(a) to “specified research or experimental expenditures.” Section 174(b) defines this term as “research or experimental expenditures which are paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business.”

Impact on Software Development

For software development expenses, taxpayers have long relied on Rev. Proc. 2000-50 to either expense or amortize such expenditures. The IRS reasoned in Rev. Proc. 2000-50 that the costs of developing computer software so closely resemble the kind of research and experimental expenditures that fall under Section 174 that they warrant similar accounting treatment. The TCJA, however, added a special rule in Section 174(c)(3), which states that, for purposes of Section 174, “any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.” This rule classifies software development expenditures as “specified” expenditures and applies the five-year or 15-year amortization requirement. It effectively limits the application of Rev. Proc. 2000-50 to software acquisition expenditures only.

Effect on R&D Tax Credit

The TCJA made a conforming amendment to Section 41(d)(1)(A) to define “qualified research” as research “with respect to which expenditures may be treated as specified research or experimental expenditures under section 174.” Previously, taxpayers were able to claim the Section 41 tax credit for expenditures that either qualified under Section 174 or were deducted under IRC Section 162 as “ordinary and necessary” business expenses. Now, with the change in the definition of “qualified research,” taxpayers must classify those expenses under Section 174 to receive the Section 41 credit. This change will require a greater focus on validating Section 41 expenditures claimed as “specified research or experimental expenditures” under Section 174.

The TCJA also made a conforming amendment to IRC Section 280C, which prevents a double benefit by disallowing deductions for the portion of otherwise deductible qualified research expenses equal to the amount of the credit determined under Section 41(a). For amounts paid or incurred in tax years beginning after December 31, 2021, Section 280C(c) provides that no deduction is allowed for that portion of qualified research expenses otherwise allowable as a deduction for the tax year that is equal to the amount of the credit determined under Section 41(a). This results in a dollar for dollar increase in taxable income for the amount of credit to be claimed (e.g., a $100 R&D credit requires a corresponding disallowance of $100 of R&D expense deduction).

To avoid this modification to taxable income, taxpayers can make an election under Section 280C(c)(2) on a timely filed tax return to reduce the credit by 21 percent, the maximum corporate tax rate. The capitalization and amortization requirement, however, will prevent taxpayers from having Section 41 credits that exceed the allowable deduction, making a Section 280C(c)(2) election unfavorable.

Change in Accounting Method

The change to amortization constitutes a change of accounting method for taxpayers that previously deducted R&E expenditures. The change will be made on a “cutoff basis,” as only expenses for tax years beginning after December 31, 2021, must be amortized. Taxpayers will not be required to make an IRC Section 481 adjustment. The IRS has yet to release new procedural guidance specifically addressing how taxpayers must comply with the new rule, and it is unclear at this time whether taxpayers will be required to file an Application for Change in Method of Accounting (Form 3115).

Possible Legislative Changes

Historically, there has been broad bipartisan support for using expensing of R&D costs to encourage research activities, and the recently stalled Build Back Better Act would have delayed these changes until December 31, 2025. Congress could still pass a standalone bill to repeal the TCJA changes to Section 174. However, with the stalled legislative agenda and a political environment that has prevented quick action on legislation, this seems unlikely. Taxpayers should plan under the assumption that the amortization requirement will not be repealed.

For information about how this change may affect your business, contact us. We are here to help.

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