The required capitalization requirements under Section 174 have created numerous challenges for businesses since they first took effect at the beginning of 2022. Such capitalization of research and experimentation expenses has raised many technical questions, while typically increasing annual tax liabilities. On Sept. 8, 2023, the IRS responded to a selection of those technical issues in the form of Notice 2023-63. Much of this guidance is consistent with our prior interpretations, so taxpayers might not need to do anything in advance of the extended 2022 filing deadlines in most circumstances. Our tax professionals analyze this guidance and its implications.
What happened with Section 174?
Historically, Section 174 permitted businesses to deduct research and experimentation (R&E) expenditures in the year incurred. However, effective Jan. 1, 2022, a provision of the Tax Cuts and Jobs Act (TCJA) took effect and now requires R&E expenses associated with research conducted in the United States to be capitalized and amortized over a five-year period (15-year period for research conducted outside of the United States).
On September 8, leading up to the extended due dates for 2022 tax returns, the IRS released Notice 2023-63 with nonbinding guidance on how to apply Section 174. The Notice provides insight into how the IRS is viewing a variety of issues, including some identified gray areas, but it also leaves a significant number of questions. Taxpayers will have to wait a bit longer to get answers.
For Section 174, what should taxpayers do right now?
Do taxpayers need to rush out to update their previously filed tax returns or revise their not-yet-filed returns on the doorstep of extended filing deadlines? Fortunately, in the vast majority of cases, the answer is no. Much of the guidance in the Notice is consistent with the expected interpretations that taxpayers might have already followed. Further, adherence to the guidance is not currently required, even though taxpayers are permitted to rely on it for their 2022 tax years. So, while most taxpayers aren’t required to pivot for 2022, they may still want to consider changes if the guidance draws a significantly different conclusion than the ones used to prepare their 2022 returns. Adjustments to positions to adopt the Notice could be made prior to filing tax returns or by filing amended or superseding tax returns, as appropriate.
Fortunately, most positions surrounding R&E costs are methods of accounting. Therefore, to the extent that guidance does require a different position to be taken, an accounting method change will generally be permitted. This generally provides for a Section 481(a) adjustment to “catch up” the cumulative effect of the change in the current tax year. Typically, a change that increases taxable income is recognized over four years, while favorable adjustments are recognized immediately. The IRS has already provided guidance in the Notice to permit accounting method changes to be made to comply with the Notice. While the exact terms of accounting method changes in this area may shift over time, this concept may provide further comfort for taxpayers in taking appropriate positions that might not entirely align with the Notice.
What’s in Notice 2023-63?
Expenses captured by Section 174 — The Notice illustrates which types of costs should be treated as R&E expenses. Such costs include:
- Wages (including benefits) of employees and contractors who perform, supervise, or directly support R&E activities.
- Allocations of rent, utilities, insurance, taxes, repairs and maintenance, security, and other similar overhead costs of facilities and equipment used to support R&E activities.
The Notice also clarifies that certain general and administrative expenses are never included such as interest, administrative functions (such as HR or accounting), and costs related to hosting or adding content to a website.
Contract research — The treatment of research performed under contract has previously been particularly unclear. The Notice provides a bit of clarity:
- Contract research provider — The Notice provides a two-element “or” test for research providers. First, if the research provider has a risk of losing money if the research is unsuccessful, then its costs under that contract are R&E expenses. If the first tier doesn’t result in R&E, the research provider will still have R&E expenses if (1) the results of the research are subject to protections under the law and (2) the research provider has the right to use the results of the research in its trade or business.
- Contract research recipient — The Notice provides that the person who hires another to perform research on their behalf would have R&E expenses under the principles set forth in the current Section 174 regulations. The Notice leaves some holes for taxpayers to grapple with as there is no further elaboration on this point.
Since the definitions of research provider and research recipient aren’t aligned with one another, the Notice acknowledges that it’s possible for both parties to a contract to have R&E expenses for the same activity. This is an area that is likely to evolve as guidance progresses from the Notice to final regulations.
Software development — The TCJA changes to Section 174 broadened the definition of R&E to include all software development, even if the software development didn’t rise to the level of R&E under prior law. However, since tax law is generally not very technologically savvy, it was not clear what was “in” or “out.” The Notice provides a definition of computer software that largely aligns with existing guidance under Rev. Proc. 2000-50 and the Section 197 regulations. The Notice specifies the following in its definition:
- The development process includes planning, designing, and coding.
- Upgrades and enhancements are software only if they result in additional functionality or materially increase the speed or efficiency of the software.
- Testing, bug fixes, and maintenance after placing the software in service aren’t considered development, unless it rises to the level of an upgrade or enhancement.
- Installation activities, configuration of purchased software, and employee training aren’t considered software development.
- Software development performed under contract follows the same contractor rules discussed above.
Long-term contracts under Section 460 — Taxpayers who have construction or manufacturing contracts under Section 460 are generally required to recognize revenue as the related costs are incurred and deducted. The Notice indicates that taxpayers should amortize R&E costs, but that only the amortization is included in the completion factor. It’s intentionally vague as to whether the denominator of the completion factor should include all R&E expenses associated with a contract or only the amortization expected to be incurred before the contract’s completion. While questions remain, this is generally a favorable development compared to prior concerns that the IRS would require all R&E expenses to be included in the numerator of the completion factor when incurred, even though the deduction occurs over time through amortization.
M&A transactions after Section 174 capitalization — The TCJA amendments to Section 174 provided that the disposition of R&E-related property doesn’t result in a deduction for the remaining basis of capitalized R&E costs and that amortization must continue. Taxpayers who previously capitalized R&E costs and then sold their business might have a lot of questions on the scope of this rule. The Notice provides that a corporation will generally continue to amortize its previously capitalized R&E, even following a sale of the assets of a business or contribution of the property to another corporation. A deduction by the corporation of the remaining R&E basis would only be permitted at the time the corporation liquidates in a taxable liquidation. However, the Notice provides an exception for certain tax-free reorganizations or liquidations that fall under Section 381, in which case the successor will continue the R&E amortization. Notably, the Notice explicitly doesn’t address transactions involving partnerships, continuing to leave many taxpayers in the dark about the appropriate treatment of their capitalized costs.
Foreign research and cost-sharing arrangements — The Notice clarifies how to determine if costs are classified as foreign and subjected to 15-year amortization. If the costs relate to research conducted outside the United States, including costs incurred in the United States attributable to research performed overseas, the costs are treated as foreign. The Notice also clarifies how parties to a cost-sharing agreement should treat R&E capitalization requirements, including the determination of how cost-sharing payments made or received by each party should be allocated among the types of expenditures.
Where do we go from here with Section 174?
The Notice is welcome news in that it provides more clarity around Section 174, albeit with limitations. The rule permitting taxpayers to rely on it in its entirety for 2022 tax years is particularly helpful for situations where the Notice provides taxpayer-favorable interpretations. That said, this guidance doesn’t address all questions and the IRS has requested comments on several issues. This means that future proposed regulations are expected to fill in many of the remaining gaps and refine the rules included in the Notice.
We anticipate a long path between the Notice and final regulations that are more binding on taxpayers. As the regulatory process advances, the guidance will likely evolve at both the proposed and final regulation stages based on comments provided to the IRS. The Notice includes a provocative note that future regulations will apply to tax years ending after Sept. 8, 2023, (e.g., 2023 calendar year tax years). This raises a question as to whether that effective date will stick even though final regulations aren’t expected to be released until well into 2024. However, in any event, those final regulations won’t be required for the 2022 tax year.
Discussions continue in Congress about deferring or repealing the Section 174 amortization provisions, with broad, bipartisan support for a change. Notably, such legislative support has existed for multiple years and yet limited actions have been taken up to this point. This suggests that expectations about potential congressional action should be tempered in the near term. Ultimately, timelines on any future congressional or IRS actions remain uncertain. In the meantime, Notice 2023-63 helps fill in a few blanks as many taxpayers apply the requirement to capitalize R&E expenses to their businesses for the first time.
To learn more about how Section 174 could affect your business and for updates on guidance and the law, please keep an eye on our website and contact your Plante Moran advisor.
