IRS Research Guidance Simplifies Rules But Has Potential Traps

Beginning in 2022, the Tax Cuts and Jobs Act requires amortization of Section 174 research or experimentation expenditures over five years for domestic R&E and 15 years for foreign R&E. This is a change from past practice, and the TCJA requires this be treated as a change in method of accounting.

In the years since enactment, taxpayers have anxiously awaited further guidance from the IRS about how to file this accounting method change. That guidance finally arrived on Dec. 12 with Rev. Proc. 2023-8.

New Procedural Guidance

Under the new procedure, adopting new Section 174 rules is done with an automatic accounting method change. Accounting method changes are typically accomplished through filing a Form 3115. However, the IRS is allowing taxpayers to implement this change by attaching a statement to their timely filed tax return for the first year in which R&E amortization is effective, instead of filing a Form 3115. The statement must include this information for each applicant:

Name and EIN
The year of change
The designated change number 265
A description of the type of R&E expenditures
The amount of R&E expenditures paid or incurred
A declaration that the applicant is changing its method of accounting to amortize R&E expenditures over the applicable five-year or 15-year period and that the change is being made on a cut-off basis.

Rev. Proc. 2023-8 confirms this accounting method change is implemented on a cut-off basis, so a Section 481(a) catch-up adjustment isn’t permitted. Taxpayers that need to change the treatment of their R&E expenditures in subsequent years must file a Form 3115 with a Section 481(a) adjustment that only includes expenditures incurred in taxable years beginning in 2022 or later. The Section 481(a) adjustment is notable because under prior law, all Section 174 accounting method changes were made on a cut-off basis, regardless of the circumstances.

For taxpayers with short years filing their 2022 tax returns before Jan. 10, 2023, they’ll be treated as if they properly made an accounting method change if they properly capitalized R&E expenditures and report those amounts on Form 4562, Part IV.

Potential Traps

While Rev. Proc. 2023-8 provides welcome guidance that will simplify the adoption of these new rules for most taxpayers, there are a few traps for the unwary to consider:

What does “type” mean? The statement in lieu of a Form 3115 requires a description of the type of R&E expenditures, but the guidance doesn’t elaborate on this disclosure. “Type” may cover the income statement classification of the expenditure—compensation, payroll taxes, supplies, rent, depreciation, etc.—but could be interpreted in other ways. There’s a risk that the taxpayer’s description could be viewed as inadequate and that it hasn’t validly adopted its new accounting method.

Missing statements. The statement in lieu of a Form 3115 is generally favorable to taxpayers, but any taxpayer with R&E expenditures who doesn’t include the statement will not have properly adopted its new accounting method. While taxpayers generally will prefer to file a method change through a statement versus a Form 3115, statements of this nature can be easily missed when preparing a tax return.

Short-year returns. Taxpayers who already filed their short-year 2022 tax returns should carefully review the reporting of their R&E expenditures to ensure they were reported on the Form 4562, Part IV. If they weren’t, it’s necessary to determine whether there’s still a path to apply the transition rule. The transition rule applies to taxpayers who filed “a federal tax return” before Jan. 10, 2023, so taxpayers in this situation need to determine if an amended return can satisfy the transition rule.

Software costs. The new Section 174 rules require any software development cost to be amortized as an R&E expenditure. The automatic accounting method change doesn’t apply to leased, licensed, or acquired computer software that’s accounted for under Rev. Proc. 2000-50. That guidance permits: acquired computer software that isn’t separately stated from acquired hardware to be depreciated with the hardware, separately stated computer software to be amortized over 36 months, and leased/licensed software to be deducted as rent. However, this exception doesn’t apply to developed software, so those costs are still required to be incorporated into the automatic accounting method change. It seems likely that the portion of Rev. Proc. 2000-50 applying to software development costs will be revoked in the foreseeable future.

Making Future Accounting Method Changes

Rev. Proc. 2015-13, Sec. 5.01(1)(f) only permits an automatic accounting method change to be made once over a five-year window with respect to any item. For Section 174 accounting method changes, the “item” has historically referred to each research project. However, Rev. Proc. 2023-8 doesn’t make any reference to projects, so it’s not clear if the “item” now covers the treatment of all R&E expenditures. If that was the case, a taxpayer who adopts the new Sec. 174 rules in their 2022 tax year wouldn’t be permitted to file another automatic method change in any year from 2023 through 2026 with respect to any R&E expenditure issues.

This could have consequences for taxpayers that adopt the new Section 174 rules in their 2022 tax year but later either identify R&E projects that weren’t originally capitalized or identify additional types of R&E expenditures that didn’t get capitalized originally. These corrections may need to be made through the filing of a nonautomatic Form 3115, which needs to be filed by the end of the applicable tax year and requires a user fee to be paid to the IRS. (For 2022, that fee is $11,500.)

Where Do We Go From Here?

If Congress repeals or defers the R&E expenditure amortization rules in the coming weeks, Rev. Proc. 2023-8 likely will follow the same fate. But if R&E expenditure amortization sticks around, taxpayers will continue to look for substantive guidance from the IRS.

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

Caitlin Slezak is a senior manager in Plante Moran’s National Tax Office. She co-leads the firm’s tax accounting methods practice and advises clients on other emerging tax issues.

Emily Murphy is a partner in Plante Moran’s National Tax Office. She co-leads the firm’s tax accounting methods practice and advises clients on the tax consequences of buying and selling businesses.

Kurt Piwko is also a partner in Plante Moran’s National Tax Office. He monitors and analyzes tax legislation and other emerging tax issues as well as advises clients on tax accounting methods and the tax consequences of buying and selling businesses.