R&D Update: What’s Going On With Section 174?

HOST: BROOKS: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters.

HOST: BROOKS: Welcome to this edition of the Cherry Bekaert Tax Beat podcast. Today we're talking with Marty Karaman, leader of the firm's tax credit and incentives advisory practice. Marty and his team, as well as many U.S. business taxpayers, have been expecting and even hoping that Congress would repeal the requirement for businesses to capitalize amortized research and experimentation expenditures, sometimes called R&D expenses or R&D costs.

HOST: BROOKS: We were hoping Congress would restore immediate deductibility of these costs for income tax purposes, but that has not occurred at this point. We will talk about the changes companies face under current law, recent guidance on how to implement this change in a company's tax return, and what this means for those claiming the R&D tax credit. First of all, Mr. Marty Karaman, how are you doing, Marty?

MARTY KARAMAN: I'm doing well today, Brooks. Where are you calling from?

MARTY KARAMAN: Today, at least this part of the week, I'm in Brooklyn, New York. I'm soon going to Michigan for the weekend.

HOST: BROOKS: And as always, joining me is Sarah McGregor from Greenville, South Carolina. Sarah, how's life treating you?

SARAH MCGREGOR: Life is good, Brooks. I'm glad I'm not headed back into cold weather. The cold blast we had over the holidays was enough for me.

HOST: BROOKS: Stan might have been good to my children, but he wasn't good to my R&D tax practice. We have a recent law that was just signed that did not include what everybody was hoping for, which was a fix to the current deductibility issue. Marty, why don't you start by explaining what Section 174 costs are?

MARTY KARAMAN: As the code defines it, Section 174 costs are those directly connected to the taxpayer's trade or business and represent R&D costs in an experimental or laboratory sense. That definition is very similar to the definition for R&D expenses under the research credit, IRC Section 41.

MARTY KARAMAN: The costs that go into Section 41 have generally been considered a subset of Section 174. Section 41 specifically includes taxable wages, supply costs, and contract research costs in the U.S. for purposes of the credit. Section 174 is a much larger bucket of costs that taxpayers historically did not have to think about because those costs were currently deductible until 2022, similar to Section 162 costs.

SARAH MCGREGOR: Give us a little background about how this change came about, what's been going on the last couple of years, and why this is different now.

MARTY KARAMAN: In 2017, the Tax Cuts and Jobs Act was passed. In addition to rate reductions, the act included revenue-raising provisions, one of which eliminated immediate deductibility for R&D expenses beginning in 2022. Since 2017, it was widely anticipated that Congress would delay or repeal the capitalization requirement, but that did not happen.

MARTY KARAMAN: Under current law, for tax years beginning after December 31, 2021—meaning for most calendar-year taxpayers the 2022 tax year—costs related to research and experimentation are no longer currently deductible. Instead, they must be capitalized and amortized over five years for domestic R&D and 15 years for foreign R&D. Software development expenses are also treated as Section 174 expenses for purposes of capitalization and amortization.

MARTY KARAMAN: This change will be far-reaching for many taxpayers, whether or not they claim the research credit. Taxpayers are supposed to review their cost buckets and categorize costs as Section 174 or Section 162 and identify those that need to be capitalized and amortized.

HOST: BROOKS: This five-year amortization rule applies whether you're taking the R&D tax credit or not, which seems unfair and likely not what Congress intended. Marty, what are some practical effects of this change?

MARTY KARAMAN: For domestic R&D, the five-year amortization has a mid-year convention, so in the first year you only get one-tenth of those costs, not one-fifth. Companies preparing a 2022 tax provision will need to consider these rules when finalizing their provisions.

MARTY KARAMAN: Generally, companies engaged in R&D will report higher taxable income than they would have under immediate expensing. Companies in an NOL position may emerge from NOLs earlier than anticipated because current expenses will be lower. From an international perspective, R&D costs affect GILTI, FDII, and foreign tax credit limitations. From a state and local perspective, increased federal taxable income may increase state taxable income because many states start with federal income as the starting point.

SARAH MCGREGOR: As I recall, Section 174 previously allowed taxpayers to capitalize costs if they were in a loss position and amortize them once benefits were realized, over 60 months or longer. Now amortization starts in the year costs are incurred, not when a patent is activated or a product is sold. Is that correct?

MARTY KARAMAN: Yes. Previously, under Sections 59E and 174B, taxpayers had flexibility to identify Section 174 costs and decide year over year whether to capitalize and amortize. Now capitalization and amortization are mandatory.

SARAH MCGREGOR: Clarify how Section 174 R&D expenditures and the Section 41 R&D credit are the same and different.

MARTY KARAMAN: From a credit perspective, the expenses that go into the Section 41 credit calculation are limited. They include Box 1 W-2 taxable wages paid to employees performing R&D, supply and prototype costs, and amounts paid to U.S. contract research. Going forward, companies must expand their analysis to identify Section 174 costs in addition to Section 41 costs.

MARTY KARAMAN: Section 174 includes gross wages plus fringe and other items beyond Box 1 wages. Under Section 41, you may include only 65% of contract research expenses, so the remaining 35% of contract research will now be part of Section 174 costs. Foreign contract research must also be included in Section 174. Additionally, attorney fees and costs for obtaining patents, depreciation, facility costs, and overhead may be included in Section 174, making it a much larger pool.

MARTY KARAMAN: Section 280C required a reduction of deductions in the amount of the credit on a year-by-year basis. That will no longer apply for most companies going forward. Companies that previously took a reduced credit or made an election under what is commonly referenced as 280C(c)(3) will now take the gross credit each year, so research credits will technically increase. However, the increase in credit will generally not offset the increased tax from the loss of immediate deductions.

HOST: BROOKS: That will be complicated math, and on the surface it seems that the increased credit will not fully offset the higher tax.

HOST: BROOKS: How will this change to capitalization and amortization impact planning for R&D efforts?

MARTY KARAMAN: Companies will need to plan for higher taxable income and consider the impact on government contractors whose funded research was not eligible for the Section 41 credit. Funded research may be included in Section 174 costs. For abandoned projects, taxpayers must continue to capitalize and amortize R&E over the five- and 15-year periods. Much prior planning under Section 59E, Section 174B, and Rev. Proc. 2000-50, which helped identify capitalizable software development costs, has been superseded because most development costs will now be capitalizable and amortizable.

SARAH MCGREGOR: This is an accounting method change from expensing to capitalizing. There has been a recent revenue procedure from the IRS about how to implement this, and it seems to simplify the process for taxpayers to change methods.

MARTY KARAMAN: The IRS issued Rev. Proc. 2023-08 in mid-December to provide guidance. The procedure confirms this is an accounting method change and provides a simplified process. If you are filing your next return and did not file a timely Form 3115 for 2022, you generally do not need to file a Form 3115. Instead, a disclosure statement should accompany the return indicating the taxpayer's name and identification number, the beginning and end dates of the first taxable year in which the change is required under Section 174, a description and the types of expenditures included as R&E expenses, and a declaration that the taxpayer is changing the method of accounting. The revenue procedure also includes special rules for short taxable years and for taxpayers that may have missed the filing deadline.

SARAH MCGREGOR: It will be important for any company with research activity to include this statement in the 2022 tax return. Both the revenue procedure and the law say this change will be made on a cutoff method.

MARTY KARAMAN: The cutoff method is helpful to taxpayers. Capitalization and amortization apply to expenditures incurred in tax years beginning on or after January 1, 2022, on a go-forward basis. There is no need to undo expensing from earlier years. If a taxpayer elected to capitalize and amortize expenses in prior years, those prior elections remain in place.

HOST: BROOKS: Final observations, Marty?

MARTY KARAMAN: Collect your data and identify all potential buckets of Section 174 expenses. If you're developing software, remember those expenses are now amortizable rather than currently deductible. Prepare for the possibility that Congress may reverse this rule, but also prepare for the possibility that it will not be reversed. The law is what it is right now.

HOST: BROOKS: Sarah, final thoughts?

SARAH MCGREGOR: I would like additional IRS guidance on how software costs and software development are defined, and clearer parameters for what qualifies as a Section 174 expense. More guidance and potential safe harbors would reduce the risk of misclassification.

HOST: BROOKS: They need to give some safe harbors. What is and isn't an R&D expenditure for the credit has been debated for decades, and clarity will be important.

MARTY KARAMAN: For startup companies or those that haven't previously claimed the research credit, this rule may incentivize not claiming the credit. Some companies may avoid identifying costs as R&D to avoid the administrative burden and IRS scrutiny.

HOST: BROOKS: That's a wrap. Thank you for listening to this discussion on changes to Section 174 treatment of research and experimentation expenditures. This podcast does not provide tax advice. Please consult with your tax advisor, hopefully at Cherry Bekaert, about your specific tax issues or to discuss information from today's podcast.

HOST: BROOKS: Please email Marty Karaman any time for follow-up questions. Check the firm's website at CBH.com for the latest guidance materials on this and other tax and business topics. This concludes today's podcast. Please like, share, and subscribe. Thank you, Marty. Thank you, Sarah. Thank you to our listeners for spending your time with us.