Important Questions to Ask When Applying New R&D Expensing Rules

Changes to Section 174 of the tax code, effective for tax years starting Jan. 1, 2022, are forcing corporate taxpayers to capitalize and amortize research and experimental expenses over five years (or 15 years for R&E performed outside the US), instead of having the option to deduct these types of expenses in the year incurred.

The IRS and Treasury Department have yet to issue guidance on the new rules, other than allowing businesses to use automatic accounting method change procedures. As a result, taxpayers are relying on case law, regulations, and precedent to prepare and file 2022 tax returns. Here are some examples of the issues and challenges facing tax preparers when advising clients on the changes.

Funded Research

Companies often outsource their research and development to a related party or an external service provider. In these cases, should both parties capitalize and amortize the R&D expenses? What about taxpayers whose “business” is to provide R&D research services to other parties? If these R&D service providers have no intent or legal right to use the research in their own trade or business, are they still subject to Section 174? If not, how should R&D expenses be treated for tax purposes—as included in cost of goods sold? As ordinary and necessary business expenses?

To help answer these questions, let’s start with the basics of Section 174: Does the taxpayer have a trade or business, or have the intent to enter into a trade or business, and use the fruits of the research?

The regulations don’t define trade or business for this purpose, but case law indicates this should be a facts-and-circumstances analysis. Courts generally look at the underlying contracts and licensing agreements and expectations between the parties. Courts also consider the company’s profitability and resources to determine if taxpayers can produce and market the fruits of their research and use the technology developed through it.

As part of the Section 174 trade or business analysis, taxpayers in the context of funded research should ask:

What rights are retained by each party?
Does the R&D service provider retain any rights in the research results?
Does the taxpayer have the objective intent of entering a business related to the fruits of the research?
Does the taxpayer have the capability and realistic prospect to use the research in its own trade or business (to manufacture, license, produce, sell, or market the product or service that results out of the research efforts)?
Which party bears the financial risk associated with the developed research efforts?

Depreciation Changes

Under Section 174, R&E expenditures excludes the acquisition or improvement of land or depreciable or depletable property used with any research or experimentation. However, depreciation and depletion allowances on property used with R&E are considered Section 174 expenditures.

That raises another question: Does capitalizing depreciation costs as an R&E expense effectively extend the recognition period for such property out for another six tax years? Section 174 provides that the amortization period begins with the midpoint of the tax year in which expenses are paid or incurred.

Software Development

Section 174(c)(3) puts software development costs directly into its jurisdiction. Previously, taxpayers could rely on Rev. Proc. 2000-50 as guidance on software development expenses through its definition of “computer software” for R&E purposes. However, a plain reading of the amended statute appears to imply that Rev. Proc. 2000-50 is no longer relevant and casts a much wider net that could require all software development costs to be capitalized and amortized.

To add another layer of complexity, what about companies hired to perform software development for a third party? For example, in FSA 199930016, the IRS concluded that a company was not entitled to treat certain costs as Section 174 expenditures because in hiring software developers, the costs incurred under a standard product agreement, a standard product license agreement, and a standard independent contractor agreement were for the purchase of computer software. Although this conclusion was made before the law changed, when combined with the above uncertainties that come up in funded research situations, outsourcing software development can complicate things further.

Section 280C Changes

Previously, Section 280C(c)(1) had disallowed Section 174 deductions for R&D expenses that were equal to the amount of the Section 41 R&D credit for that year. Section 280(c)(2) had a similar rule for Section 174 costs that were capitalized, so that the amount chargeable to capital account is reduced to the extent that the R&D credit exceeds the qualified R&D expenditures. Alternatively, Section 280C(c)(3) allowed a taxpayer to elect to claim a reduced R&D credit and avoid reducing the amount of their Section 174 deduction or the amount chargeable to a capital account.

However, starting with tax year 2022, Section 280C(c)(1) says: “If the amount of the credit determined for the taxable year under Section 41(a)(1) exceeds the amount allowable as a deduction for such taxable year for qualified research expenses or basic research expenses, the amount chargeable to capital account for the taxable year for such expenses shall be reduced by the amount of such excess.”

Alternatively, a taxpayer may claim a reduced research credit amount instead of reducing its capitalized expenditures for that taxable year. If this Section 280C(c)(2) election is made, the research credit should be reduced by an amount equal to that credit multiplied by the highest corporate tax rate.

An argument could be made that if a research credit is less than the amount allowable as an amortization deduction, then no adjustment is needed under Section 280C(c) to the research credit or to the amount amortized and capitalized. If so, this may provide an enhanced permanent tax savings opportunity to mitigate the impact of the new capitalization requirement. This also could mean that the Section 280C(c)(2) election may rarely apply as of the 2022 tax year.

However, if the research credit does exceed that year’s amount allowed as an amortization deduction, could the reduction amount be less than the full credit amount?

At least for the 2023 tax filing season, changes to R&D expense treatments abound with uncertainty and unanswered questions.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Adam Quattlebaum serves as the national leader of FORVIS’ R&D tax credits practice, where he assists clients navigate R&D tax credit claims, Section 174 studies, and IRS examinations.

Yelena Sheremeta is a member of FORVIS’ national tax professional standards group, where her work includes researching and writing on various tax issues, monitoring tax legislation and guidance, risk management, quality control, and other firmwide initiatives.