R&D credit may be disqualified for prototype costs capitalized in CIP
TAX BLOG |
Favorable rules enabling taxpayers to claim the R&D tax credit on developing prototype equipment may be sabotaged when the taxpayer does not use the proper tax accounting method for the associated research and experimentation (R&E) expenditures under section 174 of the Internal Revenue Code.
Final regulations issued in 2014 clarified when costs may be deducted as (R&E) expenditures for the development of a “pilot model” or prototype. The regulations provide that the ultimate success, failure, sale or other use of the research or property resulting from the research is not relevant to determining eligibility to deduct the R&E costs. Prior to these regulations, the IRS position was that the materials were not consumed in the research process because they ended up in a fixed asset or inventory item. The regulations also clarified that the rule excluding depreciable assets from eligible R&E costs does not otherwise disqualify the costs associated with developing a self-constructed asset that ultimately will be depreciated.
While these final regulations are favorable for taxpayers that develop their own manufacturing equipment, there are traps for the unwary. In order for costs to be potentially eligible for the R&D credit, these costs must be treated as R&E expenditures from the first year they are incurred under one of the acceptable R&E accounting methods:
- Current expense
- Elect to defer and amortize the costs over not less than 60 months
- Election of special 10 year amortization
Costs that are capitalized in construction in progress (CIP) and later included in the cost of a fixed asset and depreciated are excluded from treatment as eligible R&E expenditures.
If the oversight is caught early enough, this harsh result may be mitigated by applying for a change in accounting method. However, a method change will not fix the incorrect treatment for prior years as section 174 accounting method changes are adjusted using the cut off method, which is only effective for costs incurred in the year of change and future years. Taxpayers must continue to treat all prior year costs under the prior method of accounting. We have, however, seen situations involving long-term prototype development projects where significant costs were not only denied for the R&D credit but permanently capitalized by the IRS because the statute of limitations had expired on several years of costs before the project was completed or abandoned.