R&D Considerations in the Time of Non-Deductibility

The close of 2022 means family gatherings, holiday fun and one step closer to the end of research and development (R&D) expense current deductibility. Prior to the Tax Cuts and Jobs Act (TCJA), Internal Revenue Code Section 174 allowed a taxpayer to deduct specified research or experimental expenditures in the taxable year such R&D expenses were incurred. As amended by the TCJA, for tax years beginning after Dec. 31, 2021, Section 174(a)(1) provides that specified research or experimental expenditures are not currently deductible. Instead, such expenditures must be charged to a capital account and amortized ratably over a five-year period (15-year period in the case of specified research or experimental expenditures attributable to foreign research within the meaning of section 41(d)(4)(F)) beginning with the midpoint of the taxable year in which such expenditures are paid or incurred.

In preparation for the move from deductibility to amortization under Section 174, the IRS has released procedures for taxpayers to change the treatment of R&D expenses on the fast-approaching 2022 tax return. Revenue Procedure 2023-11¹ provides a method to obtain automatic consent under Section 446 to change methods of accounting for specified research or experimental expenditures under Section 174, as amended by the TCJA.

On What Basis Is the Accounting Method Change Made?

Pursuant to Section 13206(b) of the TCJA, the change to amortization from deduction under Section 174 is to be treated as a change in method of accounting, for purposes of Section 481, initiated by the taxpayer. The change in method of accounting is made on a cutoff basis for any R&D expenditures paid or incurred in taxable years beginning after Dec. 31, 2021, meaning that no Section 481(a) adjustments are required. Generally, under the cutoff method, only the items arising on or after the beginning of the year of the change are accounted for under the new method of accounting. If items arise before the year of change, such items continue to be accounted for under the former method of accounting. Notably, audit protection does not apply for expenditures paid or incurred in taxable years beginning after Dec. 31, 2021, if a change in method is made for the taxable year immediately subsequent to the first taxable year in which new Section 174 becomes effective.

How Is the Change Made?

The automatic change in method of accounting to comply with amended Section 174 is made by filing a statement with the taxpayer's original federal income tax return for the first taxable year in which Section 174 becomes effective. The taxpayer is not required to file a Form 3115, Application for Change in Accounting Method, unless a change in the method to account for R&D expenses under Section 174 is made for a taxable year subsequent to the taxable year of the taxpayer in which Section 174 becomes effective. Therefore, for changes in subsequent tax years, a modified Section 481(a) adjustment is required to take into account R&D expenditures paid or incurred in taxable years beginning after Dec. 31, 2021. Therefore, a taxpayer with a calendar year taxable year would need to file a statement with their original income tax return for taxable year 2022 to apply the method change on a cutoff basis.

Now What?

The required method change associated with the move to non-deductibility under Section 174 is a good time to reevaluate your company's R&D tax strategy.

• Section 41 or Section 174: The unavailability of immediate deductions under Section 174 further moves the spotlight to Section 41, which provides a credit for increasing research activities.
  • Taxpayers with taxable income should consider the documentation strategy for eligibility to claim the Section 41 credit, which is now more valuable than an amortizable expense under Section 174. The Section 41 credit is available for qualified research expenses defined, in part, as "research with respect to which expenditures may be treated as specified research or experimental expenditures under Section 174." Therefore, a taxpayer that previously deducted R&D expenses under Section 174 will likely satisfy the first prong of eligibility for the credit under Section 41 for consistent activities.
  • Startups unable to utilize the credit under Section 41 should consider whether an amortizable expense under Section 174 or an immediate deduction under Section 162 is more appropriate.
• Ability to File an Amended Return: Revenue Procedure 2023-8 makes clear that an accounting method change to comply with amended Section 174 is required, either on a cutoff basis in the first taxable year after Dec. 31, 2021, or on a modified cutoff basis in a taxable year subsequent to the first taxable year after Dec. 31, 2021.
• Domestic versus Foreign Research: The length of amortization under amended Section 174 is dependent upon whether the R&D expenses are attributable to foreign research (any research conducted outside the U.S., the Commonwealth of Puerto Rico or any possession of the U.S.). The prevalence of technology and web-based research may blur the lines between foreign and domestic research.
• Audit Risk: The Inflation Reduction Act enhanced funding for IRS enforcement; accordingly, taxpayers seeking to claim a credit under Section 41 should review procedures for contemporaneously substantiating their claims far in advance of tax filing season. Taxpayers should consider the following questions in substantiating a credit for research expenses:
  • Who bears the risk of failure of the research? The taxpayer must generally carry the risk to claim the Section 41 credit.
  • Who has the rights to the research? The taxpayer with the rights to the research is eligible to claim the credit. Under Treas. Reg. Section 1.41-2(a)(1), if the research is intended to be transferred in return for license or royalty payments and the taxpayer does not use the product of the research in the taxpayer's trade or business, the taxpayer is ineligible for the credit.
  • Is the research properly considered as contract research? Only a portion of contract research expenses are eligible for the credit under Section 41.
  • Is the research for the development of internal-use software? There are limitations for claiming a credit for the development of internal-use software.
  • What documentation is available to substantiate the claim? Taxpayers should consider documents detailing that the process of experimentation is technological in nature, for the development of new or improved business component, and for a permitted purpose. Personnel with knowledge or expertise to evaluate the eligibility of research for the credit should be involved in the documentation process.

For additional information or assistance, contact the authors.

¹ Rev. Proc. 2023-11 modifies and supersedes Rev. Proc. 2023-8, which modified Rev. Proc. 2022-14, 2022-7 I.R.B. 502.

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