Taxpayers Must Change Accounting Methods for Research or Experimental Expenditures

The Internal Revenue Service (IRS) issued updated guidance for making the required accounting method changes for specified research and experimental (R&E) expenditures under IRC Section 174. Section 174 includes a taxpayer’s specified R&E expenditures for any taxable year paid in connection with its trade or business. The Tax Cuts and Jobs Act (TCJA) changed Section 174 to require taxpayers to capitalize and amortize specified R&E expenditures over 60 months. Revenue Procedure 2023-11 provides procedures under IRC Section 446 and Treas. Reg. Section § 1.446-1(e) for an automatic change in accounting method without filing Form 3115. Taxpayers that do not take advantage of the simplified procedure in 2022 will have a more difficult process in later years and reduced audit protection.

IRC Section 174 Changes

Prior to the changes under the TCJA, companies could elect to deduct R&E costs or capitalize and amortize them over 60 months. Beginning in 2022, companies no longer have the option to deduct these costs and are required to amortize them over 60 months beginning with the midpoint of the taxable year in which the expenditures are incurred. (There is a 15-year amortization period for any R&E expenditures attributable to foreign research within the meaning of IRC Section 41(d)(4)(F)). Notably, the required method does not apply to any expenditure for the acquisition or improvement of land, or for the acquisition or improvement of property to be used in connection with the research or experimentation and of a character that is subject to the allowance of depreciation under IRC Section 167 or the allowance for depletion under IRC Section 611.

Change in Accounting Method for 2022

The required change to amortize R&E expenditures constitutes a change in accounting method to which Section 446(e) and Section 481 apply. To make this change, taxpayers generally must file Form 3115, Application for Change in Accounting Method, with their timely filed return during the taxable year in which the taxpayer desires to make a change in accounting method.

Rev. Proc. 2023-11, however, provides an automatic change in accounting method, in lieu of a Form 3115, by filing a statement with the taxpayer’s original Federal income tax return for tax years beginning after December 31, 2021. The statement must include the name and employer identification number or social security number of the applicant; the beginning and ending dates of the first taxable year in which the change takes effect; the designated automatic accounting method change number; a description of the type of R&E expenditures; the amount of specified R&E expenditures paid or incurred during the year of change; and a declaration that the applicant is changing the method of accounting for specified R&E expenditures.

The accounting change is treated as initiated by the taxpayer and as made with the consent of the Secretary. It is applied on a cut-off basis, beginning with the midpoint of the 2022 taxable year, for any R&E expenditures paid or incurred in taxable years beginning after December 31, 2021, and no income adjustments under IRC Section 481(a) are allowed.

When a change in accounting method is made on a cut-off basis, no amounts are duplicated or omitted, and, therefore, a Section 481 income adjustment is not necessary or permitted. Generally, when a change in method of accounting is made without a Section 481(a) adjustment, only the items arising on or after the beginning of the year of change, or other operative date, are accounted for under the new accounting method. Any items arising before the year of change, or other operative date, continue to be accounted for under the taxpayer’s former method of accounting.

Rev. Proc. 2023-11 also provides a transition rule for taxpayers who filed a Federal tax return for a taxable year beginning after December 31, 2021 on or before January 17, when the revenue procedure was published in the Internal Revenue Bulletin. The transition rule provides that the taxpayer is deemed to have complied with the Section 446 method change procedures and the procedures in the relevant revenue procedures, including Rev. Proc. 2023-11, if the taxpayer properly reported the amount of specified R&E expenditures on Part VI of Form 4562, Depreciation and Amortization, filed with the Federal tax return, and properly capitalized and amortized such specified research or experimental expenditures in accordance with the required Section 174 method.

Change in Accounting Method Made in Taxable Years after 2022

Taxpayers that wait until after the 2022 tax year to file for the change in accounting method will have to file a Form 3115 and a modified Section 481 adjustment that takes into account only specified R&E expenditures paid or incurred in taxable years beginning after December 31, 2021. These taxpayers will also have limited audit protection. This scenario will likely apply to taxpayers that later file an amended return to account for unclaimed R&E credits and did not capitalize R&E expenditures on returns filed for 2022 and subsequent years.

Audit Protection

Taxpayers that change their accounting method for specified R&E expenditures according to these procedures in the 2022 tax year will receive limited audit protection under Rev. Proc. 2015-13. Audit protection will not apply for expenditures paid or incurred in taxable years beginning before January 1, 2022. Also, audit protection will not apply for expenditures paid or incurred in taxable years beginning after December 31, 2021 if a change in method is made for the taxable year immediately subsequent to the first taxable year in which Section 174 becomes effective.

The IRS may also change the characterization or classification of expenditures as specified R&E expenditures as defined in Section 174(b) in order to apply Section 174 as well as the procedure change to the proper amount of expenditures paid or incurred in each taxable year beginning after December 31, 2021.

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