On Dec. 23, 2022, Congress completed an omnibus spending bill, the Consolidated Appropriations Act, 2023 (CAA), that will fund the government through the fiscal year ending Sept. 30, 2023. Excluded from the bill are any modifications to the Section 174 rules requiring capitalization and amortization of research and experimentation expenses. Those rules took effect at the beginning of 2022, but many hoped for a legislative change throughout this year. Without a change, required capitalization will be fully applicable to the 2022 tax year. Section 174 is a current hot topic, and our experts explain what this means and what actions can be taken now.
The final spending bill of 2022
Following the November mid-term elections, Congress returned to consider several important bills. From a tax standpoint, businesses carefully monitored potential changes to Section 174, the Section 163(j) business interest expense limitation, bonus depreciation, and other expiring tax provisions. Ultimately all those proposals were excluded from both the National Defense Authorization Act that was completed last week and the CAA.
Tax changes that did make the final cut include retirement plan enhancements that build upon 2019’s SECURE Act and alter automatic enrollment programs, contribution limitations, required minimum distributions, and the saver’s credit, among others. In addition, a new rule limiting charitable contribution deductions with respect to certain conservation easements was included. The conservation easement provision is largely the same as was proposed as part of the Build Back Better Act, with some technical and procedural reporting adjustments.
A complicated history of Section 174
Historically, Section 174 provided more expansive deduction rules for those incurring expenditures while conducting research and experimentation (R&E). This covered operating businesses and those in the start-up phase where a trade or business was not yet in operation. Through 2021, taxpayers had options to either immediately deduct R&E expenditures, or elect to capitalize and amortize them over periods of time. Many of these expenditures could also support claims for the research and development (R&D) credit under Section 41.
The Tax Cuts and Jobs Act (TCJA) altered Section 174 but significantly deferred the effective date. Specifically, starting in 2022, R&E expenditures were required to be capitalized and amortized over either five years for expenditures incurred in the U.S., or 15 years for those incurred outside the U.S. This shift to required capitalization alters the original construction of the rule and has the effect of increasing current-year taxable income by deferring deductions into the future. Most of the tax changes in the TCJA involved reductions in tax rates and the creation of more expansive deduction opportunities. However, Section 174 is among the changes that were unfavorable to taxpayers and it was estimated to raise $120 billion of revenue over the first six years that it was to be effective.
Since the enactment of the TCJA, businesses have been anxiously monitoring Congressional actions. R&E expenditures subject to this rule are found in businesses of all sizes and across most industries. Given the broad reach of required capitalization, there have been numerous legislative proposals to either remove the rule or defer it into the future. None of those proposals were enacted in prior legislation. Thus, all hopes had been focused on the CAA. In the end, no modifications have been made to Section 174.
Procedural rules for method changes – Rev. Proc. 2023-11
Also in late December, the IRS released procedural guidance related to the amortization of R&E expenditures. The TCJA clarified that the change in Section 174 would be an accounting method change in 2022. Accordingly, Revenue Procedure 2023-11 provides guidance about how to adopt such change for the 2022 tax year. Here are the key details of that guidance:
- General rule – Typically, accounting method changes require filing Form 3115. To simplify filing, taxpayers can adopt the new required capitalization of R&E expenditures by attaching a statement to their return for the 2022 tax year. Additional details about the contents of such a statement are outlined in the Revenue Procedure.
- Short-year returns – Tax returns for 2022 that are filed before Jan. 17, 2023 qualify for a special transition rule. Specifically, such taxpayers will be deemed to have complied with the Revenue Procedure as long as the R&E expenditures were properly reported on Form 4562, Part IV.
Revenue Procedure 2023-11 is welcomed guidance that provides taxpayer-favorable procedures. However, additional questions have been raised about fact patterns that do not fit neatly within that guidance, discussed in a deeper analysis here.
What does this all mean?
The short answer is that the conclusion of the current congressional session with no action on this issue means required capitalization of R&E expenditures remains applicable to the 2022 tax year. While it’s possible for the next session of Congress to pick up the torch and retroactively modify this rule, the legislative process is much more complicated. Such legislation would need to be completed on a bipartisan basis due to Republican control of the House and Democratic control of the Senate. The 2022 tax filing season is also rapidly approaching in early 2023, which further challenges the prospect of retroactive changes.
Some businesses will have already preliminarily identified costs subject to capitalization during 2022, and now those conclusions will have to be refined and finalized. However, other businesses may have waited in hopes of a legislative fix. In any event, the coming weeks and months will be a crucial period for identifying the requisite expenditures and determining the impact on taxable income for 2022. Our recent webinar described the details of these rules and may be a great refresher course. The unfavorable tax consequences of Section 174 can also be mitigated through the R&D credit, so businesses may wish to take a fresh look at such opportunities in 2023. Additionally, the likely increase to taxable income should provide the opportunity to take an increased IC-DISC commission, which will also help mitigate some of the tax increases from Section 174.
