January 26, 2023
174 Research and Experimentation (“R&E”) Expenses paid or incurred in taxable years beginning after 12/31/2021 cannot be immediately deducted. They must be amortized over 5 years, or 15 years in the case of foreign R&E. There are several implications to this change:
1) This mandatory change will result in a short-term increase in taxable income;
2) Since there was previously no difference between Section 162 and Section 174 deductibility, many businesses will not even realize they are now affected;
3) Taxpayers have a limited time to take advantage of Rev. Proc. 2023-11 and avoid filing the complex Change of Accounting Form 3115;
4) While a change in these rules is generally expected eventually, in the immediate term taxpayers will have to account for these changes on their 2022 tax returns; and
5) The Section 41 Research and Development (“R&D”) Tax Credit is an excellent way to mitigate the effects of mandatory amortization under Section 174.
The Background: Section 174 and Section 41
In order to understand the impact of this legislation, it’s crucial to understand the relationship between Section 174 Expenses and Section 41 Expenses.
Section 174 Expenses are known as Research and Experimentation, or R&E Expenses. The expenses that fall under Sec. 174 can be divided into two categories, based on how essential each is to the activity being performed.
Section 41 Expenses are known as Research and Development, or R&D Expenses. These are known as “Direct Research Expenses,” and are what usually come to mind when you imagine research and development. Wages, supplies/materials, cloud hosting, and fees paid to 3rd party contractors are expenses integral to the research process.
However, performing a research activity requires more than just those things. You need a facility to perform the research in. You probably need to pay rent on that facility, and pay for utilities and phone lines. Maybe you need to travel as part of the research, and have associated travel costs. If you are filing for a patent, you probably have legal fees to pay. All these additional costs are considered “Indirect Research Expenses.”
So, Section 174 – R&E Expenses – includes two different categories:
- Direct Research Expenses that qualify for the R&D Tax Credit under Section 41
- Indirect Research Expenses that are generally more incidental costs
To reiterate: Section 41 Expenses are a sub-set of Section 174 Expenses. Apart from the rare exception, virtually all Section 41 Expenses are Section 174 Expenses.
The table below summarizes some common expenses with Section designation. Note that expenses for foreign or funded research do not qualify as Section 41 Expenses for the R&D Tax Credit, but are designated as Section 174 Expenses.
Before the Tax Cuts and Jobs Act (TCJA) of 2018 was passed, taxpayers could choose to immediately deduct their Section 174 Expenses or to capitalize and amortize them over a period of 5 years.
The TCJA contained a provision mandating that – beginning in Tax Year 2022 – Section 174 expenses must be amortized over 5 years or 15 years. Section 174 Expenses may no longer be immediately deducted.
The treatment of software development costs was given special mention. Software development expenses incurred in tax years starting after December 31, 2021, are no longer deductible under Rev. Proc. 2000-50. Instead, they must be treated as R&E expenditures under Sec. 174 and, as such, amortized.
The delayed rollout made many hope the provision would be repealed before it took effect, but that was not the case. Continued bipartisan support is encouraging — and we may see a retroactive repeal — but for the time being we must work with this as a new reality.
The Rev. Proc.
The IRS released Rev. Proc. 2023-11 on 12/29/2022, to guide taxpayers as they attempt to file with this provision in play for the first time.
Since it is the first time, most taxpayers will require a change in accounting method. To streamline things this year, the IRS is offering a taxpayer-friendly shortcut for TY 2022 only. In lieu of filing a 3115, taxpayers may include a notice with their original 2022 tax return indicating that the taxpayer is now amortizing the Section 174 Expenses.
The statement must include certain key pieces of information:
- Name and Employer Identification Number or Social Security Number (as applicable) of the applicant that has incurred the Sec. 174 Expenses after 12/31/2021
- Beginning and ending dates of the year of change (i.e., 1/1/2022-12/31/2022)
- Designated automatic accounting method change number for this change (#265)
- Description of the type of expenditures included in the change
- Amount of R&E expenditures paid or incurred by the applicant during the year of change
- Declaration that the applicant is changing the method of accounting for specified research or experimental expenditures to capitalize such expenditures to a specified research or experimental capital account, and amortize such amount over either a 5-year period for domestic research or 15-year period for foreign research (as applicable) beginning with the mid-point of the taxable year in which such expenditures are paid or incurred in accordance with the method permitted under § 174 for the year of change.
- Declaration must also state that the applicant is making the change on a cut-off basis.
Mandatory capitalization and amortization of Sec. 174 Expenses will certainly impact tax returns, but hopefully less than one might imagine.
It’s more of a timing issue than anything else. By amortizing the deduction over 5 years, taxpayers will see a higher net taxable income initially. Generally, taxpayers will pay more taxes in year 1 and year 2, but not more overall. In fact, most taxpayers will “break even” by year 3 and pay little to no tax in that year and beyond. Smaller firms and start-ups will likely feel the impact of the increased tax liability more deeply, even if it is only short-term.
For example, consider a taxpayer that incurs $800,000 in Section 41 Expenses, resulting in a net R&D tax credit of $60,000 annually. Based on a review of which Section 41 Expenses are also considered Section 174 Expenses, it is determined that the taxpayer has $1,000,000 annually in Section 174 expenses.
Assuming the taxpayer claims the same expenses and credit annually, the table below demonstrates how the amortization of the Section 174 Expenses will impact the amount of tax owed.
When Sec. 174 Expenses Come as a Surprise
Mandatory amortization may be a harder pill to swallow for taxpayers who didn’t realize their expenditures fell under Sec. 174. Many expenses people thought were Sec. 162 – and deductible – are actually Sec. 174 and must be amortized. We anticipate that the IRS will be looking out for 162/174 mismatches this year. 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.
Key industries that likely have Sec. 174 R&E Expenses include:
- Product Development
Again, if your primary activity falls in one of the above categories, the IRS will expect to see Sec. 174 expenditures present and correctly amortized on your return.
The Mitigating Options
Some have posited that if a taxpayer chose not to take the R&D Tax Credit, or to “skip a year,” they wouldn’t have to deal with Sec. 174. However, if a taxpayer has Sec. 174 activities, then they have Sec. 174 Expenses. Taking the R&D Tax Credit doesn’t generate additional Sec. 174 expenses.
In fact, the opposite is true — the R&D Tax Credit is an excellent way to mitigate the impact of the Sec. 174 amortization. The powerful R&D Tax Credit can go a long way towards diminishing the unfavorable tax consequences of Sec. 174 amortization. (See above example.)
The 199A Qualified Business Income (QBI) Deduction is another helpful option to consider. Qualifying pass-through entity owners may deduct up to 20% of their QBI, which would certainly help offset the additional tax liability generated by Sec. 174 amortization.
While there is a possibility that Sec. 174 amortization may be repealed retroactively later this year, it is mandatory for current filings. The IRS will be looking for compliance this tax season, and readers are encouraged to take advantage of the “shortcut” laid out in Rev. Proc. 2023-11. The short-term impact of mandatory Sec. 174 amortization will be felt, but may be mitigated by R&D Tax Credit studies and/or the 199A QBI Deduction, as appropriate.