What Companies With R&E Expenditures Should Be Doing Right Now

Section 174 now requires taxpayers to capitalize research and experimental expenditures and amortize the capitalized amount over five years (if the research is conducted in the US) and over 15 years (if the research is conducted offshore), beginning with the midpoint of the taxable year in which expenditures are paid or incurred. R&E expenditures now explicitly include “any amount paid or incurred in connection with any software development” for tax years beginning after Dec. 31, 2021.

Here are some recommendations for identifying and quantifying R&E costs, as well as some important considerations.

Recommendation No. 1: Don’t Wait

Taxpayers should engage in this process as early as possible. It will take time to identify, analyze, and quantify R&E expenditures, particularly for taxpayers that don’t claim tax credits for R&E activities. Partnerships will have even more urgency in completing the computation, as the Section 174 amount must be determined for Schedule K-1 reporting purposes.

Although the IRS and Treasury Department eventually will publish guidance, it may not address all the issues taxpayers are confronting—definitional questions, practical questions, possible exclusions from capitalization—or be published in time for taxpayers to thoroughly analyze their expenditures before providing Schedule K-1s or filing tax returns. Confronting the unknowns won’t get easier as the time to comply gets closer.

Recommendation No. 2: Build on What You Know

In developing a method to identify and quantify R&E expenditures, taxpayers should review the potential sources of information that they already have:

Section 41 research credit studies.
Book treatment for research and development costs
Cost center-based general ledger accounts
Recently filed Section 174 or Rev. Proc. 2000-50 accounting method changes
Section 59(e) election statements
Section 861 allocations

A taxpayer that computes a federal research credit under Section 41 may want to begin with qualified research expenditures, due to the overlap of R&E expenditures and QREs and determine what costs must be added for Section 174 purposes. Such additional costs include employee benefits, 100% of qualifying contractor costs, foreign research expenditures, and indirect costs such as utilities and depreciation on property used in research and development. However, there may be wages in QREs that aren’t “incident” to development activities.

Taxpayers shouldn’t overlook the best source of information: their employees. Conversations with departmental or cost center leaders, operations personnel, and technology department project managers can provide insight into research and development activities, budgets, and expenses that the tax and finance departments may not have.

Recommendation No. 3: Be Deliberate

Section 174 regulations generally define R&E expenditures as costs incurred for activities that eliminate uncertainty and refer to “costs incident to” development. Some regulation examples include salaries, heat, light, power, drawings, models, laboratory materials, attorneys’ fees, and depreciation on buildings used in research activities—but that’s not an inclusive list. As a result, taxpayers must carefully consider what types of direct and indirect costs are paid or incurred in the tax year and may be “incident” to the resolution of uncertainties (or software development).

The revised statute or existing regulations also fail to define “software development.” For this analysis, taxpayers may want to consider administrative guidance and the IRS’ legal position as expressed in court filings related to Section 41 research credit claims for software development activities.

Taxpayers should be mindful about including too much or too little when identifying R&E expenditures. The effect of Section 174’s capitalization and amortization provisions may have varied outcomes for tax computations, based on taxable income or allowable deductions under Section 163(j), FDII, or Section 199A. Thoughtful analysis and modeling are the keys to understanding whether capitalization and amortization of R&E expenditures will help or harm the taxpayer, and if the business structure or operational changes can enhance or mitigate the consequences.

Recommendation No. 4: Pay Attention to Process

Once taxpayers identify and quantify Section 174 costs, they need to consider how to track the amortization of the capitalized costs. Because Section 174 allows amortization to begin in the year the cost is incurred and doesn’t allow for any cost recovery sooner than allowed under the amortization period, there may be significant differences between book and tax treatment of the cost recovery for R&E expenses.

If the taxpayer has both foreign and domestic R&E expenditures, they may need to establish two pools of costs, one for each category of R&E expenditures (foreign and domestic), as the amortization of the capitalized amounts is over different periods. The statute doesn’t provide explicit rules for how taxpayers should track or account for Section 174 costs.

The IRS and Treasury Department issued Rev. Proc. 2023-11 to implement an accounting method change to comply with Section 174. For the first taxable year beginning after Dec. 31, 2021, taxpayers can attach a statement to their federal income tax return in lieu of a Form 3115. For a year of change later than the first taxable year beginning after Dec. 31, 2021, the taxpayer must complete a Form 3115 and compute a modified Section 481(a) adjustment, which should account for only specified R&E expenditures paid or incurred in the taxable year.

Recommendation No. 5: Think Ahead

All the effort that taxpayers put into identifying and quantifying R&E expenditures for 2022 should be documented for future years. Process insights, identifying the best sources of information, and understanding how costs are categorized and tracked are valuable know-how that should be documented.

Structural and business operations changes related to R&E activities or expenditures that help future processes, enhance benefits, or mitigate detriments may become more apparent after a thorough evaluation of a taxpayer’s costs and activities. A taxpayer may want to translate that knowledge into action to achieve better outcomes, if it aligns with other business needs. For example, it may be more favorable for taxpayers to acquire an asset versus developing it (even if the asset is foreign-developed) if the acquired asset is depreciated more quickly or is eligible for bonus depreciation under Section 168(k).

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

Cate Stewart is a tax senior manager at Ernst & Young LLP US in the national tax department and specializes in US research credits.

Alexa Claybon is a tax principal of Ernst & Young LLP US in the national tax department. She is the firm’s technical leader for the US federal R&D credit practice.