What is the status of section 174?
Every so often, an article is written with the hope that, while informative, its utility and usefulness over time is of limited effect. This is such an article. Stated another way, should Congress once and for all agree to restore the prior-law elective expensing of research and experimental (R&E) costs under Internal Revenue Code section 174 expenditures, the only action required of impacted taxpayers would be determining whether to currently deduct or capitalize qualified costs.
Alternatively, should Congress decide to restore prior law relief but on a temporary basis – for example, allowing taxpayers the ability to expense R&E costs for one or two years – this could convert the matter into a perennial yearly exercise that will discourage innovation.
In the midst of such uncertainty, as taxpayers approach the end of the calendar year, absent Congressional action, many taxpayers are understandably unsure of how to account for their R&E costs.
Prior to 2022, taxpayers had the option to either deduct their R&E costs or to capitalize and amortize such costs over a period of not less than 60 months. Under the new law, that option has been eliminated.
As part of tax law changes enacted in 2017, commonly referred to as the Tax Cuts and Jobs Act (TCJA), starting in 2022, Congress requires taxpayers to capitalize expenditures that qualify as section 174 costs and recover them over 5 years (with a 1/10th first-year deduction under a half-year convention) for domestic expenditures, and 15 years (with a 1/30th first-year deduction under a half-year convention) for expenditures attributed for foreign research.
As part of the law change, Congress also required the development of any software to be treated as section 174 expenditures, thus requiring their capitalization under section 174.
Section 41 starts with all the taxpayer’s section 174 expenditures then further winnows that down by imposing additional rules. Taxpayers often jump straight to allowable section 41 costs to calculate the R&D credit, bypassing any section 174 analysis. If the excluded costs were a section 174 expenditure, it was generally deducted. If the excluded cost was not a section 174 expenditure, it was probably a section 162 cost so why spend time deciding what section to deduct the cost under.
There is broad bipartisan support to repeal the required amortization and go back to the optional capitalization or immediate expensing of section 174 expenditures. Unfortunately, while an idea may have broad bipartisan support, Congress is often not compelled to act immediately on these items due to other political factors. The solution in many instances becomes a captive of partisan bickering, or worse, political grandstanding, A recent example - - while there was broad bipartisan agreement that, due to a drafting error, qualified improvement property should have had a 20-year life and be subject to bonus depreciation (commonly referred to as the retail glitch), it took over two years to correct the issue, which was then done retroactively. Now that the midterm elections are over, all eyes will be on potential tax discussions as part of a lame-duck session through the end of this year. While there is ample opportunity to intercede in the matter during the lame-duck session, one could see Congress not being able to reach a consensus on the issue and leaving the resolution for the next Congress. In such a scenario, nothing would likely be done until January or later.
What are the Issues?
Timing of action
One area of focus is whether there is much difference between action this December or next January on the issue. For corporations that have audited financial statements, their provision tax calculations must be done as dictated by the law in effect during the applicable year. If Congress fails to act before the end of this year, corporations must prepare their provisions by capitalizing their section 174 costs and amortizing them over 5 or 15 years as appropriate.
Book R&D costs
Another area of focus is whether taxpayers can use their book R&D costs. In general, the answer is probably not. The rules for Generally Accepted Accounting Principles and section 174 are not the same and could lead to material distortions if one was used for the other. Adding to the confusion, the rules indicating what expenditures are section 174 costs have not been well developed. Practitioners are not even in agreement, as a technical matter, on how broadly a section 174 should be defined.
Expansive scope of qualifying costs under section 174
The legislative history under the TCJA is silent on a detailed definition of a section 174 expenditure (aside from the inclusion of software development as a section 174 expenditure). However, the legislative history does address deferring the recovery of such expenditures. This would suggest that Congress only intended to defer section 174 expenditures, and self-developed software, and not create new definitions.
The existing regulations under section 174-2, defines R&D as:
[E]xpenditures incurred in connection with the taxpayer's trade or business which represent research and development costs in the experimental or laboratory sense. The term generally includes all such costs incident to the development or improvement of a product. The term includes the costs of obtaining a patent, such as attorneys' fees expended in making and perfecting a patent application. Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. … Whether expenditures qualify as research or experimental expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents.
The regulations go on further to define the expenditures not by what expenditures may qualify, but through the exclusion of certain expenditures. Those categories of expenditures that do not qualify as R&D include quality control expenditures, efficiency surveys, management studies, consumer surveys, advertising or promotions, the acquisition of another patent, or research in connection with literary, historical, or similar projects. By negative inference, this could widen the scope of the provision, and the broader nature of costs that the IRS could assert should be included thereunder (as compared to the narrower category of “qualified research costs” under the R&D tax credit rules.)
Direct labor vs indirect costs
In light of the expansive interpretation of what constitutes a section 174 expenditure, the extent to which costs beyond direct labor could be considered a section 174 expenditure is unclear. Among other open issues is the question of whether the IRS will require a proportionate share of indirect costs as sectuib 174 costs, resulting in an approach that is similar to UNICAP.
Such approach would create three categories of expenditures:
- Expenditures that are clearly section 174 costs.
- Expenditures that are clearly not section 174 costs.
- Expenditures that both benefit R&D activity and activity other than R&D.
This last category of costs may require an allocation between category one and category two. For example, human resources would apply to R&D workers and would also apply to workers that do not engage in R&D activities. The existing regulations under Reg. section 174-2(a)(1) define section 174 expenditures to include “all such costs incident to the development or improvement of a product”. The IRS could take the approach that incidental costs are those that can be found in bucket three. While the IRS has a project to address what is a section 174 expenditure, it may not be a high priority if Congressional action on section 174 is taken.
Another interesting issue will be the interplay of section 174 with the IRS’s position on supplies consumed during R&D. Currently the IRS examination position seems to be that supplies constitute a valid section 174 expenditure under a very narrow interpretation, despite an example specifically allowing supplies under Treas. Reg. §1.174-2(b)(5) Ex 1. Will the IRS now suddenly shift course and say that most supplies are section 174 expenditures to defer the recovery over 5-15 years?
The new rules will impact research-dependent industries such as life science companies (or software development businesses still in the start-up phase). Generally, section 174 expenditures escape the application of being classified as “start-up costs” under section 195, which generally requires expenditures that qualify as an expenditure under section 162 to be capitalized and recovered over 15 years once the taxpayer begins their business. As most of these taxpayers’ expenditures during the startup phase would seem to qualify as section 174 costs, this could cause a life science company to be in a taxable position much earlier than anticipated (by virtue of the capitalization requirement), especially with the limitations on using net operating losses at 80% of current income.
A worst-case scenario is that Congress fails to act this year on section 174. This, in turn, could impact the recordkeeping compliance burden upon taxpayers. Normally, the section 41 R&D credit is one of the last items needed for the Federal income tax return. Since it is just a credit calculation, taxpayers only need the information after determining taxes owed for the year.
This dynamic gets shifted when the current year R&E deduction under section 174 shrinks to 1/10th for domestic activity and 1/30th for non‑domestic activity. Remember that the amortization rules use a half-life convention so that taxpayers only get 50% of the first-year‑ amortization and recovers that difference in the 6th or 16th years, depending on if the expenditure is related domestic or non-domestic R&D. So now a taxpayer with significant R&D expenditures may have to determine their section 174 costs and sourcing in the beginning of the tax return process as they now have to defer 90%+ of the section 174 deductions to future years.
Hoping for the best; planning for the worst
To date, most taxpayers’ approach is that since there is broad bipartisan support for restoring prior law, the issue will go away, and taxpayers will not have to do anything in response. This may work if the start date of the section 174 required amortization is deferred prior to December 31, 2022 (ignoring the impact to taxpayers with short-year returns that start in and end in 2021 because of a transaction). If the start date is pushed into 2023, then those with audited financial statements may need to undergo the exercise for provision purposes for 2022.
Now imagine if Congress lets this slip past January. Also, imagine a taxpayer’s Federal income tax results feeds up into other multiple tax returns in a tiered structure. Because the income results feed up into multiple other tax returns, the taxpayer historically has filed their Federal Income tax return in March. If Congress does not immediately address the issue, how much time does a taxpayer need to determine its proper section 174 expenditures and properly source the expenditures? For a company that now finds itself in a taxable income position when it was not projecting income until years later (due to the significant current R&D spend), a Congressional deadlock on the issue, with no corrective action before April 2023 invokes many questions. For example, are there systems in place to address the capitalization and amortization of section 174 expenditures? Does the tax return provider have the resources to engage in a study that was not planned for in February or March? Does the organization have the cash on hand to pay taxes? Congressional inaction can lead to a lot of awkward scenarios.
How should taxpayers prepare?
Taking into account some of these scenarios, how does a taxpayer position itself in the midst of this uncertainty to avoid significant disruption? Does the taxpayer perform a study allocating indirect costs when ultimately the study could prove unnecessary? There are some benefits of looking at refining section 174 expenditures, such as increasing the R&D credit or bolstering deductions for those taxpayers in the start-up phase of the business governed by section 195. In addition, should the results be needed for provision purposes, then those would already be available.
Should a taxpayer conduct a high-level study to determine the potential impact? Does the taxpayer pre‑schedule time with their service provider in case Congress does not address the issue in January? These are questions not easily answered, although as a matter of prudence, taxpayers do not want to be in a position of scrambling to find resources in February when the return is intended to be filed in March. At a bare minimum, taxpayers need to have a plan in place should Congress fail to act in a timely manner to ensure that they have the resources to adequately address the delay or determine the information necessary to complete a timely filed income tax return.