When the Section 174 rules requiring capitalization and amortization of research and experimentation (R&E) expenses went into effect in 2022, taxpayers grappled with questions about how to apply required capitalization treatment to expenses that had been currently deducted for years. This was especially true for taxpayers computing income related to long-term contracts under the percentage-of-completion rules of Section 460. The IRS released guidance in September 2023 on the treatment of R&E expenses, which also shed some light on R&E expenses incurred in relation to long-term contracts, but many questions remain. Below, we examine the issues taxpayers are facing and considerations when applying these rules.
The Section 460 problem
In general, when a contract meets the definition of a long-term contract, it’s required to apply the percentage-of-completion method (PCM) of accounting under Section 460. Under this method, expenses allocable to the contract are generally deducted as incurred while revenue is recognized by multiplying the total contract price by the completion factor. The completion factor is determined by dividing the allocable contract costs incurred to date (the numerator) by the total allocable contract costs anticipated to be incurred over the course of that contract (the denominator). This causes the gross profit on the contract to be recognized in proportion to expenses incurred.
Historically, R&E expenses were required to be included in both the numerator and the denominator of the completion factor to the extent they were allocable contract costs. However, with R&E expenses now required to be capitalized, there is debate about whether the PCM rules should still permit the immediate expensing of R&E expenses that are allocable contract costs. If the R&E expenses are still required to be capitalized, there is debate about what amounts to include in the numerator and denominator of the completion factor (i.e., the full amount of the expenses or just the amortization incurred before the contract is completed).
Recent IRS guidance on Section 174
On Sept. 8, 2023, Treasury released Notice 2023-66 (the Notice), which contained interim guidance on the treatment of R&E expenses, including those that are allocable contract costs. The Notice provides that Treasury plans to issue regulations that would require taxpayers to include the amortizable portion of Section 174 costs in the numerator of the completion factor. The Notice didn’t conclude on what amount to include in the denominator and requested comments from the public on that issue. Taxpayers aren’t required to follow interim guidance, but the Notice provides a clear view of Treasury’s current position that the PCM method doesn’t override the general requirement to capitalize and amortize R&E expenses and that only amortization of R&E expenses are included in the numerator of the completion factor.
What are your options for Section 174 and long-term contracts?
Taxpayers grappling with how to treat R&E expenses in a long-term contract have a few different scenarios to consider.
Scenario No. 1: Immediately deduct R&E expenses
R&E expenses allocable to a long-term contract aren’t required to be capitalized. In effect, this would be identical to the approach that would have existed in 2021 and in earlier years when R&E expenses weren’t required to be capitalized and amortized. A taxpayer taking this position would argue that Section 460’s focus on measuring taxable income by deducting allocable contract costs takes precedence over the Section 174 capitalization and amortization with respect to any R&E expenses allocable to long-term contracts.
Scenario No. 1 example: In year one, Acme Construction has $150 in total R&E expenses, all of which are currently deducted, and $200 in other costs. In Scenario No. 1, R&E expenses are treated as currently deductible and aren’t capitalized. Thus, $350 (the sum of $150 in currently deducted R&E expenses and $200 in other costs) is included in the numerator of the completion factor. Acme Construction also has $550 in estimated total allocable contract costs in the denominator. Thus, Acme Construction’s completion factor for year one is 64%. Acme Construction’s total contract revenue is $1,000, and when the completion factor is applied to the contract revenue, the product is $636 in contract revenue. This leaves $286 of gross profit for year one.
This scenario conflicts with Notice 2023-66, which states that Treasury’s view is that Section 174 costs must be capitalized, even if allocable to a long-term contract.
Scenario No. 2: R&E amortization in numerator of completion factor
Only the amortized R&E expenses for the year are included in the numerator of the completion factor, while the total R&E expenses are included in the denominator.
Scenario No. 2 example: Same facts as the Scenario No. 1 example except the $150 of R&E expenses is capitalized and amortized, so that $15 in R&E expense amortization exists in year one. Thus, $215 (the sum of $15 in R&E expense amortization and $200 in other costs) is included in the numerator of the completion factor. Acme Construction still has $550 in estimated total allocable contract costs in the denominator. Thus, Acme Construction’s completion factor for year one is 39%, causing year one contract revenue of $391. This leaves $176 of gross profit in year one.
Because gross profit under the PCM is driven by expenses incurred, Scenario No. 2 is a more favorable result in year one because fewer expenses are recognized. However, if the contract ended before the R&E expense amortization period expired, then gross profit might be recognized on a more accelerated basis than Scenario No. 1 because at the end of the contract all revenue would be required to be recognized even though amortization expense would continue after the contract was otherwise completed. This scenario is consistent with Notice 2023-66 with respect to the capitalization of R&E expenses and the amortization included in the numerator. Since the Notice doesn’t directly address the denominator, it doesn’t conflict with the Notice in that respect.
Scenario No. 3: R&E amortization in numerator and denominator of completion factor
Only the amortized R&E expenses for the year are included in the numerator of the completion factor and the denominator includes only the R&E expense amortization anticipated to occur during the life of the contract.
Scenario No. 3 example: Same facts as the Scenario No. 2 example except that Acme Construction anticipates the contract to be completed by the end of year two, so only the $45 of R&E amortization is included in the denominator of the completion factor. The numerator is still $215 (the sum of $15 in year one R&E expense amortization and $200 in other costs), but the denominator is now $445 ($550 of total costs less $150 of R&E expenses plus $45 of anticipated R&E amortization occurring in years one and two). Thus, Acme Construction’s completion factor for year one is 48% causing year one contract revenue of $483. This leaves $268 of gross profit in year one.
Scenario No. 3 will generally always be less favorable than Scenario No. 2. It will generally be more favorable than Scenario No. 1 in the early years of the contract but less favorable in later years for the same reason as Scenario No. 2. This scenario is consistent with Notice 2023-66 with respect to the capitalization of R&E expenses and the amortization included in the numerator. Since the Notice doesn’t directly address the denominator, it doesn’t conflict with the Notice in that respect.
Scenario No. 4: All R&E expenses included in completion factor but still capitalized to measure taxable income
R&E expenses are capitalized and amortized to determine the expenses deducted during the year, but the completion factor is determined by disregarding that capitalization.
Scenario No. 4 example: Same facts as Scenario No. 1 except that Acme Corporation’s deductible expenses only include R&E expense amortization for year one of $15. Therefore, the completion factor is still 64% determined by including all R&E expenses and disregarding the fact that they are otherwise capitalized and amortized. This results in the same $636 of year one revenue as in Scenario No. 1. However, the deductible expenses would only include the $200 of other costs incurred in year one and the $15 of R&E expense amortization in year one. This leaves gross income of $421 of gross income in year one.
This will consistently be the least favorable method for taxpayers. This scenario conflicts with Notice 2023-66 since the Notice only requires R&E expense amortization to be included in the numerator of the completion factor. However, the scenario is consistent with previous IRS guidance under the former voluntary R&E expense capitalization rules.
When it comes to Section 174 and Section 460, where do we go from here?
While the year one gross profit of the taxpayer in each of the examples above is dramatically different, the income over the full term of the amortization period will be the same. In the year following completion of the contract, Section 460 generally requires taxpayers to include in gross income any portion of the total contract price not yet recognized. Thus, taxpayers taking positions that reduce income inclusion in the early years of the contract may have to report a significant income inclusion after the contract ends. This can create a significant timing difference in many circumstances, which can put meaningful pressure on cash flows. Each scenario has varying degrees of strength, some of which are stronger than others. Most taxpayers have also already taken positions on their 2022 tax returns, which may limit the flexibility they have for their 2023 tax returns.
Treasury is planning to release proposed regulations in the future addressing the application of the Section 174 rules to long-term contracts, as well as other Section 174 issues. These proposed regulations are expected to provide additional information to taxpayers for how to address R&E costs in long-term contracts, but it’s unclear when that guidance will be released. It’s also unclear whether and how taxpayers will be permitted to adopt that guidance since all PCM-related changes are otherwise required to be adopted on a cutoff basis. Eventually, those rules will become final, and all taxpayers will be required to adopt the rules in the final regulations. Therefore, even if a more or less advantageous method is selected now, a taxpayer will eventually be able to conform to the singular set of final rules by making an accounting method change.
In the meantime, it’s important for taxpayers to consider all the pros and cons of each alternative, including potential risks associated with positions that aren’t consistent with Notice 2023-66. Taxpayers may need to consider disclosing their tax positions on their returns or filing nonautomatic method changes, depending on their unique circumstances.
