Section 174 New Requirements and Its Impact on Technology Companies

TIM LARSSON: Welcome to the Cherry Bekaert technology podcast. I am Tim Larsson, a tax partner in Cherry Bekaert’s Technology Group.

Today, we have Marty Carman, Dan Mennel, and Carolyn Smith Driscoll from our Tax Credits & Incentives Advisory practice to discuss new requirements for taxpayers under Internal Revenue Code Section 174 and what it means for technology companies.

Could each of you start by introducing yourselves to our audience?

MARTY CARMAN: Thanks, Tim. This is Marty Carman. I am a partner in our Tax Credits & Incentives Advisory group, and I am happy to be here today.

DAN MENNEL: Thanks, Tim. This is Dan Mennel. I sit in Silicon Valley, so this is a timely conversation on the impact of these rules for the tech community.

CAROLYN SMITH DRISCOLL: Thanks, Tim. This is Carolyn Smith Driscoll. I am a director in the Tax Credits & Incentives Advisory group.

TIM LARSSON: Thanks, everyone. Today, we are going to talk about the implications of Internal Revenue Code Section 174.

While it may seem like a simple accounting method change on the surface, it has real implications for tech companies regarding research and software development costs.

Dan, do you mind kicking us off by providing an overview of the rules surrounding Section 174?

DAN MENNEL: Thanks, Tim. Most experts and lobbyists thought Congress would fix this law in the course of 2022, but that did not happen.

Historically, R&D costs under Section 174 were no different from a timing perspective than the cost of goods sold or other ordinary and necessary costs. All costs could be deducted in the year incurred.

However, the Tax Cuts and Jobs Act (TCJA) amended Section 174 to require the capitalization and amortization of R&D expenditures effective for tax years beginning after 2021.

The amended Section 174 law requires capitalization of R&D and software development costs, amortized over five years for domestic R&D and 15 years for foreign R&D.

Due to a mid-year convention, a taxpayer only gets to deduct one-half of the amortization in the first year. For domestic R&D with a five-year life, the taxpayer only gets to deduct 10% in year one.

This is a significant impact for our clients. Many companies that were historically in a loss position may no longer be, as only 10% of R&D is allowed to be deducted.

This may also mean many companies that were previously on the fence regarding the R&D credit are now looking at it as an option.

Additionally, under Section 174(c)(3), the law provides that all costs related to software are to be treated as R&D. This is a big hit for the tech community, and we are helping clients work through this issue.

TIM LARSSON: Taking that into consideration, it would be helpful for our audience to understand the differences between the R&D credit, which is governed by Section 41, and Section 174. Marty, can you tell us what those differences are?

MARTY CARMAN: Absolutely. The research credit has been around since 1981 and has always been a significant benefit for taxpayers.

It is probably more imperative than ever that companies look at it. There is a misnomer that if a company does not claim a research credit, they will not have to recognize Section 174 costs.

That is definitely not true. Section 174 is not optional.

The costs that go into a research credit under Section 41 include wages for those performing research in the U.S., supply costs, some cloud costs, and amounts paid to third-party contractors.

Section 174 includes a larger group of costs beyond that, including depreciation, overhead, utilities, patent application costs, and attorney fees.

Because Section 174 costs are broader than those associated with the Section 41 credit, your Section 174 costs will likely be higher than your Qualified Research Expenses (QREs).

The amount that needs to be capitalized will be higher than the actual credit calculation.

One positive change Congress made was to Section 174(b), which now defines "specified research expenditures."

Additionally, Section 280C was changed such that the credit only has to be tax-affected to the extent the credit itself is larger than the Section 174 amortization in a year. This will almost never happen outside of rare circumstances.

The credit is now more valuable because it is no longer tax-affected. If you claim a traditional research credit, you get the full 20% credit; if you claim the Alternative Simplified Credit (ASC), you get the full 14% credit.

You now receive the full statutory rate on the credit, but it will not fully offset the tax effect due to the capitalization of all Section 174 costs.

TIM LARSSON: Based on my experience so far, Section 174 is not new, but the lack of a repeal has made it very impactful.

For my clients in the technology space, particularly SaaS companies, this has been a major shift.

Many practitioners thought this provision would be repealed, but since it was not, it applies universally.

We have seen companies with losses for book purposes move into a taxable income position because of the required capitalization and the first-year amortization haircut.

While this is a timing difference, growth-mode companies may not recoup those tax benefits for some time.

Some clients have asked about planning options, such as offshoring intellectual property, but that is not an immediate solution. It has opened a whole new dialogue with our clients and prospects.

Carolyn, can you talk us through the allocation of overhead and the methodologies our audience should consider?

CAROLYN SMITH DRISCOLL: Thanks, Tim. Section 174 is much more expansive than the Section 41 credit.

All R&D expenditures paid or incurred in connection with a trade or business that represent costs in the experimental or laboratory sense must be capitalized and amortized.

The guidance allows for any reasonable method of allocation.

One method is using R&D employee headcount over total employee headcount and applying that ratio to overhead expenses.

Alternatively, you can use R&D gross wages over total company gross wages.

Other factors include whether the company has multiple locations and whether development professionals are limited to specific sites.

Sometimes overhead general ledger accounts are already broken out by R&D or engineering, in which case further allocation might not be necessary.

We also receive many questions regarding software development versus services. Software development is a broad term, and there is currently a lack of guidance.

We suggest looking at rights and risk, which is the traditional evaluation used to determine if research is funded under Section 41.

You must look at the underlying activities to determine if the company is performing services or development.

For example, is the company merely installing and configuring off-the-shelf software, or are they developing software specific to a client? This requires a deep dive into contracts and activities.

DAN MENNEL: Carolyn brought up some relevant points. Because this is a gray area, it is important to consult with your tax return preparer.

When navigating issues like subcontractor rights to IP, you want to understand your preparer's position and their willingness to sign the return based on those conclusions.

MARTY CARMAN: One additional planning opportunity involves third-party development.

If a company can change contractual terms to purchase software from a third party rather than having development performed on their behalf, those costs may not be Section 174 costs.

The purchase of software is not a Section 174 cost, which provides some flexibility in the software area.

TIM LARSSON: Carolyn, Marty, and Dan, thank you for sharing your insights. There is a lot to unpack, and the impact of Section 174 on technology companies should not be taken lightly.

Thank you to our listeners for tuning in. To stay up to date on the latest accounting trends affecting technology companies, be sure to subscribe to the Cherry Bekaert technology podcast.

Thank you and have a great day.