Internal Revenue Code Section 174 has long been used by taxpayers to deduct certain expenses related to research and experimentation (R&E) in the current year. The code section was originally enacted in 1954 to eliminate uncertainty in the tax accounting treatment of Research and Development (R&D) expenditures, with the legislative intent to encourage taxpayers to carry on research and experimentation and create innovation within the US.
The immediate expensing that Section 174 allowed was radically changed with the Tax Cuts and Jobs Act (“TJCA”) of 2017. The TJCA amended Section 174 to require capitalization of all R&E costs over either a 5- or 15-year period, beginning after December 31, 2021. Although there was essentially a 5-year period for taxpayers to become comfortable with the change in rules under Section 174, the new rules are now in play and represent significant tax implications as taxpayers begin to navigate the new regime.
Under the former rules, taxpayers could treat certain expenses as R&E expenses, with some discretion. The TCJA amendments now use the language “shall”, and therefore require R&E expenses to be classified under Section 174. Because R&E expenses were treated as immediately deductible under the original rules, similar to the immediate deduction of other expenses, many taxpayers did not spend an extraordinary amount of time focusing on the precise allocation of expenses to Section 174. This will change and taxpayers are now confronted with carefully reviewing their R&E expenses to ensure compliance.
How do the new rules effect taxpayers?
The most recognizable tax impact is the initial increase in tax liability that will be created due to capitalization. Instead of deducting R&E expenses in the current year, Section 174 now requires those same expenses to amortized over a 5-year period (15-year period for costs attributable to foreign research). This is a timing difference, but it does not numb the effect of potentially increased annual tax liability until the full amortization of the expenses. Taxpayers who capitalize expenses under Section 174 should be prepared to see an increase in estimated tax payments. In addition, due to the timing difference, Section 174 will create a deferred tax asset and that may have an impact on tax provisions.
The capitalization could also create foreign tax issues, including an impact on global intangible low-tax income (GILTI) and the usage of foreign tax credits. This demonstrates the far-reaching impact of the change and should be reviewed carefully to ensure compliance with foreign tax positions.
The change from immediate expensing to capitalization is a change in accounting method, which the Internal Revenue Service (“IRS”) recently addressed in Rev. Proc. 2023-8. The revenue procedure contained some favorable news for taxpayers, as a Form 3115 – Application for Change in Accounting Method – is not required in the first year taxpayers are affected by the change. In lieu of a Form 3115, taxpayers are permitted to provide a statement with their tax return in compliance with the procedures laid out in Rev. Proc. 2023-8 to facilitate the change in accounting method.
What does this mean to taxpayers who engage in some sort of research and experimentation?
Now, R&E expenses must be carefully reviewed and capitalized under Section 174. This may have a direct impact on estimated taxes, current year tax liability and foreign tax positions, each of which must be evaluated diligently. However, it may also present an opportunity for some taxpayers, as an increase in Section 174 expenses may result in an increase of expenses eligible for the Section 41 tax credit. In addition, taxpayers who have expiring net operating losses may be able to increase their utilization due to the increase in tax liability. There is, and has been, bipartisan support for a repeal or modification of the new rules, but any political efforts have been stalled. The reality is that the new rules are now in effect and taxpayers need to be aware of the implications.
Frazier & Deeter’s Credits and Incentives team can help taxpayers navigate these new rules, especially during this time of transition. Whether it’s determining the appropriate costs to be capitalized under Section 174, consulting to ensure compliance or maximizing the tax credit, our team of experts is ready to help.
For more information contact:
Tommy Zavieh | Tommy.Zavieh@frazierdeeter.com
Sheila R. Anderson | Sheila.Anderson@frazierdeeter.com
Allen Tobin | Allen.Tobin@frazierdeeter.com