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Section 174 Amortization

Have you been deducting your R&D expenses as they occur?  Starting in 2022, that option is obsolete pending any legislation change for year end.  You now have to amortize them over multiple years.

The IRS requires business owners to amortize Section 174 research expenses, which are qualifying research expenses or “QREs,” over multiple years instead of deducting them in the year incurred unless the provision in the Tax Cuts and Jobs Act changes before December 31.  Through 2021, businesses could deduct Section 174 expenses in the year in which they were incurred or capitalize and amortize the costs over period of time not less than five years. But this new provision eliminates the former option.  Sec. 174 expenses associated with research conducted outside the U.S. will be capitalized and amortized over a 15-year period.

This change could significantly impact your business’ financial statement and cash flows, especially if you’re involved in technology and life sciences and conduct a lot of research — instead of a tax loss, your firm would have a taxable profit.  Costs that you’ve been deducting for research costs may not be deductible in 2022.

If, for instance, your business spent $100 on domestic research activities in 2021, you can deduct the full $100 of Sec. 174 expenses in that fiscal year.  But in 2022, if you again spend $100 on research, you’ll have to deduct it incrementally over a five-year period.  This could lead to an unexpected increase in your taxable income, especially in the first few years these rules will apply.

If you have filed an extension, it’s important to note both the R&D credit and estimated Section 174 expenses have been accounted for in your 2022 tax provisions and extension payments.  This extension serves two purposes:

  • It allows potential changes in legislation and its retroactive application.
  • It grants additional time for the issuance of guidance toward the calculation of Section 174 expenses.

A comprehensive FAQ sheet is available to assist you further.  It addresses common Sec. 174-related concerns and includes relevant technical advisement.

Recent legislation introduced by Congressmen Ron Estes (R-KS) and John Larson (D-CT), along with Senators Maggie Hassan (D-NH) and Todd Young (R-IN) aims to repeal R&D amortization.  Currently, there are no additional legislative updates regarding this issue.  We invite you to petition lawmakers to cosponsor legislation that will repeal R&D amortization.  Please use this link to contact your representatives and senators.

Frequently Asked Questions

1. Where do these rules currently stand?  Is there any pending legislation that can change this.

As it stands, the TCJA requirement that all Section 174 (R&E) expenses be amortized over a 60 (domestic) or 180 (foreign) month period are still in place.  There have been two bills introduced in 2023, one in the Senate and one in the House of Representatives that would repeal this change in treatment:

Senators Tom Young (R-Ind) and Maggie Hassan (D-NJ) introduced the American Innovation and Jobs Act on March 15, 2023.  This legislation would allow for the immediate expensing of Section 174 expenses and also increased the ASC rate from 14% to 20% for startup businesses.

Representatives John Larson (D-CT) and Ron Estes (R-KS) were joined by 60 bipartisan co-sponsors in introducing the American Innovation and R&D Competitiveness Act on April 18, 2023, which also provides for the immediate expensing of R&E costs.

2. What does that mean in the short term?

For calendar-year filers, CPA’s have recommended (and are still recommending) that taxpayers calculate direct Section 174 costs (along with Section 41 R&D expenses), make the appropriate tax provisions and extension payments as if the capitalization requirement remains in place, but extend the return in anticipation of a legislative change, further guidance on Section 174 expense calculation, or both.

3. What can we do in the meantime?

We know that DIRECT R&E expenses must be calculated/amortized and have a process in place for the calculation.  This includes:

  • R&E Wages related to qualified projects with the gross wage adjustment made.
  • The full value of contract research expenses
  • Supplies/Computer Lease Expenses
  • Patent procurement expenses (primarily legal fees and filing costs)
  • Foreign research expenses
  • Non-qualified software development expenses

AICPA has reached out to the IRS with a request for clarification on calculation of indirect costs, expenses that fall within the definition of “software development”, and examples of what expenses “incident to development” should include.  We are anxiously awaiting this guidance, but as of May 3, 2023, it has not been issued.

Once this guidance is issued, your CPA will have solutions for calculating these expenses.  If this guidance is not issued by July 15, 2023, they will state their position based on the guidance available at that time as it will take time to gather any additional information.

4. How does the 280C election work with these new rules?

AICPA has also sought clarification from the IRS on the applicability and treatment of Section 280C on R&D credits where the underlying expenses must be capitalized, and as of today none has been issued.  Strict reading of the conforming amendment to the Tax Cuts and Jobs Act (TCJA) indicates that electing to take the full, non-280C reduced credit would be appropriate and would not require an addback of expenses except in rare cases where the R&D credit exceeded the amount being deducted.  This is contradictory to the 2022 Form 6765 Instructions, which indicated otherwise.  CPA’s have taken the position that until further clarification is issued, the conforming amendments to the TCJA outweigh the form instructions and have encouraged taxpayers and tax practitioners to take this route (with the caution of uncertainty).

5. With the change in accounting method, do I need to file a Form 3115?

No.  In late 2022, the IRS issued Rev. Proc. 2023-8 and 2023-11 which state that if the 2022 return is the first year that the change in accounting method occurs and Section 174 expenses are capitalized, then a taxpayer may do so by filing a statement in lieu of 3115.  Taxpayers that capitalize expenses for the first time in years after 2022 will be required to file a 3115 and note any adjustments necessary under Section 481(a).

6. What else is still in question?

Lots.  The IRS and Treasury Department have included “guidance addressing amortization of R&E expenditures” on its Priority Guidance Plan for 2021-2022, but as of today nothing has been issued.  Key questions left outstanding:

  • What is the definition or scope of R&E activities? Section 174 specifically excludes costs related to acquiring land or other property for R&E activities and costs for mineral exploration, and now specifically includes software development costs, but otherwise does not define R&E expenditures.
  • How should indirect costs be treated?
  • How are R&E costs treated when a contractor performs R&E services for a client and the contractor is not at risk and has no ownership rights in the resulting IP? Are the contractor’s costs subject to Section 174 capitalization?
  • How does R&E capitalization impact the rules under Reg.1.861-8 (dealing with computation of taxable income from US and other sources and activities), Reg.1.861-17 (dealing with allocation and apportionment of R&E expenditures), and the cost-sharing regulations under Section 482?
  • How should R&E capitalization be treated under UNICAP? Section 263(a) provides that the UNICAP rules do not apply to amounts “allowable as a deduction” under Section 174. Is Section 174 amortization a production cost subject to UNICAP, or does the Section 263(a) exclusion apply to the ‘deduction’ for amortization?
  • How are software development costs defined? For example, do they include installation of acquired software?