FAQ: Capitalization and amortization of R&D costs under new section 174 rules

A: R&D expenses are not specific types of costs. Instead, they are determined by the activity a taxpayer undertakes. R&D expenses are present if a taxpayer develops a new or improved product or service or develops software.

Taxpayers developing a new or improved product or service must be uncertain whether the intended functionality or capability can be developed or about the appropriate design needed to achieve the intended functionality or capability. In this circumstance, the taxpayer undergoes a process of experimentation that is technological in nature to resolve the uncertainty.

Typical project expenditures subject to capitalization include:

• Researchers’ wages, including nontaxable benefits
• Contract research expenditures (100% versus 65%)
• Direct research supervisor wages for researchers
• Cost of supplies
• Overhead expenses, including rent, utilities, and depreciation
• Depreciation on equipment directly used or allocated to an R&D activity
• Costs attributable to a pilot model
• Expenditures for software development

A: In the absence of specific guidance, taxpayers must use a reasonable approach to interpreting the law.

The law provides the instruction of Congress to defer the recovery of R&D expenses over five or 15 years. There is nothing to suggest that Congress intended to change the definition of R&D expenses aside from including software development costs. Because of this, until the IRS issues further guidance, it is reasonable to continue to rely on guidance under section 174 as it existed before amendments by the TCJA.

A: While not every business will have R&D expenses, many do, especially if it produces goods or incurs expenses related to software development (i.e., websites, mobile applications, enterprise resource planning systems, etc.). Generally, businesses with engineering departments, R&D departments, or those that report R&D expenses in their financial statements have significant R&D expenses.

A: Section 174 covers a broader range of activities and costs than those that qualify for the R&D tax credit under section 41. Generally, costs that qualify for the R&D credit will also be treated as section 174 costs; however, the inverse is not true.

For example, wages that qualify for the R&D tax credit are limited to Box 1 wages (or self-employment earnings in the case of a sole proprietorship). But section 174 qualifying wages include additional wage amounts, such as nontaxable benefits and retirement contributions. There is a so-called “substantially all” rule for the R&D credit where taxpayers may claim 100% of Box 1 wages for employees that spend 80% or more of their time performing qualifying activities—this does not exist for section 174.

When it comes to payments made to third parties to perform contract research, only 65% of eligible contract research expenses are included toward the R&D credit, whereas 100% may be eligible for inclusion as a section 174 cost. Additionally, section 174 costs include allocable overhead costs, such as rent and utilities, as well as the depreciation of equipment used in the R&D process, and patent legal expenses that aren’t included in qualifying R&D tax credit costs.

It's important to note that all computer software development costs are now considered section 174 costs. For R&D credit purposes, there is a higher threshold for software development initiatives to be eligible for the credit in the case of software developed by the taxpayer for internal use. There is no such threshold for section 174, so taxpayers may notice a much higher section 174 cost compared to what is claimed for R&D credit purposes for software development initiatives.

A: It’s possible. Some taxpayers forgo taking the R&D credit for various business reasons but still have R&D expenses. Also, expenditures paid or incurred in software development are considered R&D expenses and may not be captured in an R&D credit study.

A: Generally and without IRS guidance, there is no right or wrong way, although costs should be allocated based on a reasonable methodology. Many practitioners deem reasonable methodologies to include allocations based on employee headcount or square footage (similar to section 263A methodologies). Alternatives that best align with a business’s facts and circumstances can also be used.

A: In the absence of specific guidance addressing this issue, RSM’s view is that companies that provide contract research services and do not retain risks or rights to the underlying research are service providers and would have section 162 expenses, not section 174 expenses.

Any agreements should be reviewed to determine whether the risks and rights retained by each party give rise to section 174 expenses.

A: In the absence of specific guidance addressing this issue, RSM’s view is that a company that engages a third party to perform research on the company’s behalf has section 174 expenses if the company maintains the risks and rights to the underlying research.

Any agreements should be reviewed to determine whether the risks and rights retained by each party give rise to section 174 expenses.

A: With cost reimbursements, the taxpayer receiving reimbursement may not have an expense to capitalize. A rights/risk analysis of the work performed is likely required first to see which party should be treated as incurring section 174 expenses.

A: No, not without a book safe harbor provided by the IRS or Treasury Department. In addition, the GAAP research numbers may not include software development costs. However, knowing the total amount of research costs capitalized for book purposes may provide a starting point for determining the scope of activities to include in the tax R&D expense analysis.

A: No, the taxpayer’s financial statement treatment will still be governed by the appropriate financial accounting standard (GAAP, etc.). Section 174 applies to tax treatment only.

A: Regardless of the abandonment of the underlying property, capitalized R&D expenses costs will continue to be amortized over the respective 5- or 15-year period.

A: Generally, state conformity to the federal tax code must be reviewed state-by-state. While some states automatically conform to changes to the code for state income tax purposes (called rolling conformity states), many others have fixed-date conformity or only conform to specifically enumerated provisions.

Accordingly, it is critical to understand whether the state conforms to the TCJA changes made to section 174. Most, but not all, states have updated their conformity dates or specific conformity provisions to incorporate changes made by TCJA or otherwise conform to the provisions through rolling conformity to the code.

A: As an example, at least one state, Tennessee, has enacted specific legislation to decouple from the federal capitalization requirements under section 174 and allow state-level current expensing. Other states may propose or enact legislation to decouple from the federal capitalization rules during the 2023 or 2024 legislative sessions.

A: Some states have differing conformity rules for corporations and pass-through entities, creating a disconnect between proper state treatment of expenses under section 174 for differing entity types. Pass-through entities should consider these differences, especially because conformity to section 174 is often addressed in a corporate context.

A: Some state R&D computations reference federal section 174 rather than section 41. As taxpayers analyze section 174 expenses for federal purposes, it may be beneficial to reclassify some costs as deductible under a different federal code section, where possible, to preserve current deductibility for federal purposes. Such a reclassification could have a negative impact on the state R&D credit for jurisdictions that reference section 174 as the basis for the state-level credit computation. This is a nuanced and state-specific analysis.

A: The timing of federal legislation is a key factor for fixed-date or selective conformity states. With most state legislatures out of session by the beginning of summer, there is a distinct possibility that some states will not be able to respond to federal legislation timely. Changes to federal provisions, effective in 2023 or earlier, may not be conformed to by many states until 2024 state sessions or later.

A: While there is broad bipartisan support to repeal or defer the required capitalization of R&D expenses, Congress did not come to an agreement to do so before the 117th Congress adjourned at the end of 2022.

A bill to reinstate full and immediate deductibility was introduced in the Senate on March 16, 2023, and is co-sponsored by seven Republicans, five Democrats, and one independent. However, despite that example of bipartisan support, RSM’s tax policy team believes it is very unlikely that the 118th Congress will make any changes to section 174 because the two parties have different political priorities.

Further, retroactivity in future legislation is uncertain. Ultimately, taxpayers must proceed with the current state of the law and capitalize and amortize their R&D expenses.

A: The IRS released a revenue procedure with the procedures and terms and conditions for a taxpayer to change its method of accounting for R&D expenses. Substantive guidance has not yet been issued as of late March 2023, and we do not expect additional guidance in this area until late spring or summer of 2023 at the earliest.

A: Taxpayers eager to share their thoughts directly with policymakers can communicate with their local congressional representatives. RSM’s tax policy team members have found that congressional staffers appreciate hearing from taxpayers and businesses to better understand the real-world ramifications of their actions or lack thereof.