Navigating the gray areas in the Section 174 capitalization rules

As 2022 came to a close without any action by Congress to modify or repeal the new capitalization requirements for Section 174 research and experimentation (R&E) expenditures, the reality set in for many taxpayers that they can no longer deduct R&E expenditures like they have in the past. The new Sec. 174 requirements will have meaningful consequences for some taxpayers, like significant increases in current year taxable income. While the IRS has released limited procedural guidelines, questions around implementing the new rules remain unanswered.

Why is implementing the new Section 174 rules so complicated?

The idea behind the new Sec. 174 rules seems fairly straightforward: Taxpayers have to capitalize and amortize their R&E expenses over five years for domestic expenses and 15 years for foreign expenses. But the Sec. 174 rules are now compulsory for taxpayers with R&E expenses when, historically, taxpayers were allowed to elect whether to use the Sec. 174 rules in their businesses. This results in taxpayers having to ask questions that haven’t been necessary before, like what expenses must be treated as R&E? Which parties are required to apply the Sec. 174 rules when multiple parties are involved in R&E activities? These and many other questions continue coming up as taxpayers grapple with the new rules. Below are some of the most complex issues surrounding the new Sec. 174 rules that taxpayers should think through.

These and many other questions continue coming up as taxpayers grapple with the new rules.

Who has Section 174 expenses in contract research arrangements?

Contract research includes research performed by one party on behalf of another pursuant to a contract. Treasury regulations provide that Sec. 174 applies both to expenses undertaken directly by the taxpayer or expenses undertaken by a contractor on behalf of the taxpayer. This means that the party paying for the research can capitalize the costs they pay to the contractor. However, it’s unclear if the contractor performing the research must also capitalize their expenses under Sec. 174. Factors such as which party to the contract has technical uncertainty, bears the risks of the project, and has rights to the development or improvement are helpful in determining whether the contract researcher has Sec. 174 expenses. However, none of these factors are dispositive, and available guidance on this issue is sparse. Contracts where related parties are involved in the contract research, where the research is being funded by a third party, or where third-party equipment is involved may require additional analysis when considering whether the taxpayer qualifies for Sec. 174.

What are software development expenses, and do they have to be capitalized under Section 174?

Sec. 174 doesn’t define software or software development, but the new Sec. 174 rules require that “any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.” This leaves lots of taxpayers wondering if their computer programming or coding expenses might have to be capitalized. Whether a taxpayer’s costs were incurred in connection with software development, as opposed to some other type of computer-related work, is a fact-specific inquiry that depends on various factors. The complexity of the work performed, the types of expenses incurred, and whether the work was performed under a contract may all play a part in the analysis of this issue. Taxpayers that think their activities may fall under Sec. 174 should document all activities and expenses related to software development and work with their tax advisors to determine whether their expenses must be capitalized.

Should taxpayers still be making Section 280C elections?

Sec. 280C is intended to prevent a taxpayer from taking a Sec. 41 research credit and a Sec. 174 deduction based on the same expenses. Qualified research expenses (QREs), which are used for the research credit, are a subset of Sec. 174 expenses, so a taxpayer may have Sec. 174 expenses that aren’t QREs. In the past, Sec. 280C required that the amount of QREs included in a Sec. 174 deduction must be reduced by the amount of the research credit the taxpayer claimed in the same tax year. Taxpayers are allowed to make an election to take the entire Sec. 174 deduction and reduce the amount of their research credit instead, which is a choice that many taxpayers have historically made.

Starting in 2022, Sec. 280C requires that if the amount of the Sec. 41 research credit exceeds the “amount allowable as a deduction” for research expenses, the amount chargeable to capital account shall be reduced by the amount of the excess. This suggests that only the amortizable portion of the research expenses capitalized under Sec. 174 is considered “an amount allowable as a deduction” under Sec. 280C. If that’s the case, taxpayers no longer have to reduce amortization deductions of capitalized Sec. 174 expenses by the amount of the research credit, and instead, they only have to reduce the deduction if the amount of the research credit exceeds the amortizable amount of the Sec. 174 deduction. This may make the research credit more valuable to many taxpayers. Taxpayers will have to reconsider their approach to Sec. 280C starting in 2022, and the benefits of making an election will vary for different taxpayers depending on their circumstances.

Which research-related costs should be allocated under Section 174?

Indirect costs are costs incurred in relation to research activities but not the direct result of research activities. Common examples include overhead costs and wages. While indirect costs are subject to Sec. 174, it’s unclear which indirect costs Sec. 174 applies to. Like other areas related to R&E expenses, documentation will be important in determining which indirect costs need to be allocated. Unfortunately, the IRS hasn’t published guidance on which indirect costs need to be allocated to Sec. 174, and there’s no prescribed method for doing this allocation. Indirect costs will need to be addressed with every Sec. 174 calculation, so taxpayers should budget the time to evaluate the facts and circumstances relevant to the indirect expenses they incur in their R&E activity and identify a reasonable method for allocating those costs.

Additional Section 174 considerations for mergers and acquisitions

Taxpayers involved in mergers and acquisitions starting in 2022 and beyond will have to consider the implications of Sec. 174. Because there is little IRS guidance on the new rules, parties to a transaction should negotiate around the possibility that future guidance changes their pre-closing tax liabilities. Some questions parties should consider during negotiations are how changes to pre-closing tax liabilities will be shared, who will be responsible for filing an amended return, and whether Sec. 174-related tax adjustments have been recorded in the target’s financial statements and how they would impact expectations and representations.

Taxpayers involved in mergers and acquisitions starting in 2022 and beyond will have to consider the implications of Sec. 174.

What should taxpayers do now?

Now is the time for taxpayers to act. There are many unanswered questions related to the new Sec. 174 rules, and determining the best path to address those questions may take significant time and planning for some taxpayers with R&E expenses. Our professionals can help taxpayers navigate the Sec. 174 gray areas and determine the best approach to handling R&E expenses for their business.