September 14, 2023
On Friday September 8th, the IRS released long-awaited guidance addressing the mandatory amortization of Section 174 expenses.
It isn’t the news we were hoping for.
Notice 2023-63, discusses the scope of Section 174 at length, clarifying the nature of qualifying expenditures and how they must be amortized. Yes, at least for now, they must be amortized.
The IRS promised that proposed regulations will be released, and those regulations will be consistent with the guidance in Notice 2023-63. Until those proposed regulations are released, taxpayers can rely on Notice 2023-63 for tax years ending after 9/8/2023, as long as the rules are applied consistently.
(One caveat: taxpayers may not rely on the rules in section 7 of the notice for SRE expenditures paid or incurred with respect to property that is contributed to, distributed from, or transferred from a partnership.)
Also coming — guidance providing procedures for taxpayers to obtain automatic consent to change methods of accounting to comply with the Notice. Until then, taxpayers may rely on section 7.02 of Rev. Proc. 2023- 24 to change their methods of accounting under Sec. 174.
What are SRE Expenditures?
SRE (Specified Research or Experimental) Expenditures are defined as follows in the TCJA:
Research or experimental expenditures that are paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business. This definition applies for any tax year beginning after 12/31/2021.
SRE Expenditures Include:
- Labor Costs: Labor costs of full-time, part-time, and contract employees and independent contractors who perform, supervise, or directly support SRE activities.
- Materials and Supplies Costs
- Cost Recovery Allowances: Depreciation, amortization, or depletion allowances with respect to property used in the performance of SRE activities or in the direct support of SRE activities, including property placed in service in a taxable year that begins on or before December 31, 2021.
- Patent Costs: Costs of obtaining a patent, including relevant attorney’s fees.
- Certain Indirect Research Expenses: Rent, utilities, insurance, taxes, repairs and maintenance costs, security costs, and similar overhead costs are considered SRE Expenditures.
- Travel Costs
What are NOT SRE Expenditures?
- Costs incurred by general and administrative service departments that only indirectly support SRE Activity – payroll, HR, etc.
- Interest on debt to finance SRE activities
- Costs to input content into a website
- Costs for website hosting
- Costs to register an Internet domain name or trademark
Why Does the Notice Stress “Consistent Treatment of Costs”?
The Notice requires that SRE costs be treated as SRE for all provisions of the IRC.
We’ve cautioned readers about this before – the IRS is looking for mismatches, and this consistency requirement is another hint that they will be scrutinizing returns. The IRS will absolutely not permit a taxpayer to treat an expenditure as an SRE expenditure for purposes of Sec. 41 (R&D Tax Credit) while simultaneously deducting that expense as an ordinary and necessary business expense under Sec. 162.
In short, if your activities indicate that you should have Sec. 174 Expenses, the IRS will be closely reviewing your return to make sure they’ve been amortized appropriately.
What about Software Development?
The TCJA added § 174(c)(3) to clarify that all expenditures paid or incurred in connection with software development should be treated as a research or experimental expenditure (and thus an SRE expenditure when paid in connection with a taxpayer’s trade or business.)
Notice 2023-63 provides an overview of which software-related activities will and will not qualify under Sec. 174, but again, this is not the final word. The IRS promises additional proposed regulations that will define which software expenditures must be amortized regardless of whether or not they would otherwise be considered Sec. 41 expenses.
Until those regulations are released, we can rely on guidance from this Notice regarding qualifying activities:
Activities That Can Be Treated as Software Development Under Sec. 174:
- Planning the development
- Designing the computer software
- Building a model of the computer software
- Writing source code and converting it to machine-readable code
- Testing the software and fixing any errors that arise, but only until
- The software is placed-in-service (if being developed for use in the taxpayer’s trade or business), or
- The computer software is ready for sale or licensing to others
Activities NOT Considered Software Development Under IRC §174:
- Rollout and maintenance of software developed by a taxpayer for use in its trade or business – actually installing the software, dealing with any programming errors, training employees in how to use it, etc.
- Marketing and promotional activities
In conclusion, Notice 2023-63 isn’t the gamechanger people were hoping for, but it’s also not the end of the story. The IRS promises additional regulations that will further flesh out this guidance, and there are multiple bills still in play in Congress.
We encourage readers to make their voices heard. Why not encourage your local representative to co-sponsor one of these crucial bills?
To see if your representative has already signed on, visit the Congress.gov pages for the American Innovation and Jobs Act and the American Innovation and R&D Competitiveness Act of 2023.
The IRS promised that proposed regulations will be released, and those regulations will be consistent with the guidance in Notice 2023-63.
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