The Internal Revenue Service (“IRS”) released Notice 2023-63, on September 8, 2023, providing guidance surrounding the requirement to capitalize Section 174 research and experimental (“R&E”) expenditures for the 2022 taxable year.While many tax accountants and business professionals welcome the additional guidance, the timing was not ideal.
The guidance was issued seven days before the 2022 calendar year federal tax extended deadline for S corporations and partnerships, and 38 days before the extended deadline for C corporations. The good news is if a taxpayer has already filed or solidified their Internal Revenue Code (“IRC”) §174 R&E position, the taxpayer is not required to amend or adjust their position for the 2022 taxable year. The guidance is not effective until taxable years ending after September 8, 2023. However, a taxpayer can apply the rules provided in the Notice if they rely on all the rules and apply them consistently. Even though the Notice only provides a short window to adjust a 2022 tax return, it could be worth the time and effort if the cash tax savings are significant.
The Notice highlighted and expanded the application of IRC §174 to R&E expenditures paid or incurred by the taxable year in connection with the taxpayer’s trade or business. The IRS highlighted that the taxpayer does not need to be carrying on a trade or business, but instead merely incur expenditures in connection with a trade or business. As a result, more taxpayers will be required to assess IRC §174. The Notice specifically references the Snow v. Commissioner case in which the Supreme Court firmly established that pre-operational R&E expenditures are IRC §174 R&E expenditures.
The term R&E expenditures, as defined by the regulations, includes expenditures incurred in connection with the taxpayer’s trade or business, representing 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 IRS could have interpreted the word incident to be expansive, applying a broad scope to indirect costs, forcing more costs to be capitalized under IRC §174. However, the recent Notice provided a reasonable application of what expenditures would not be considered under IRC §174 R&E expenditures, including:
- General and administrative service department or function costs that only indirectly support or benefit R&E activities (e.g., payroll, human resources, accounting)
- Interest costs on debt to finance R&E activities
- Costs incurred for non-development computer software activities
- Costs to input content into a website
- Website hosting costs paid to an internet service provider
- Costs to register trademarks or internet domain names
- Quality control testing, efficiency surveys, management studies, consumer surveys, advertising and promotions, the acquisition of another's patent, model, production or process, or research in connection with literary, historical, or similar projects
- Amortization of R&E expenditures paid or incurred in tax years beginning before January 1, 2022
- Labor costs of employees and contractors who perform, supervise or directly support R&E activities. However, the Notice did clarify that severance compensation does not need to be included in labor costs.
- Costs of materials and supplies used or consumed in the performance of R&E activities or in the direct support of R&E activities
- Cost recovery allowances (e.g., depreciation) of property used in the performance of R&E activities or in the direct support of R&E activities
- Costs of obtaining a patent, such as attorney fees expended in making and perfecting a patent application
- Certain operation and management costs (e.g., rent, utilities, insurance, taxes, repairs & maintenance) for facilities and other assets used in the performance of R&E activities or in the direct support of R&E activities
- Travel costs for the performance of R&E activities or the direct support of R&E activities
IRC §174 was modified for taxable years beginning after 2021, to include any amount paid or incurred in developing software, whether internal or external, as a R&E expenditure. Before the Notice, what constituted software development was undefined. Therefore, taxpayers were forced to rely on the IRS’s application of software development for the IRC §41 research credit as provided in the audit guidelines and regulatory authorities.
The Notice defined computer software as a computer program, a group of programs, and upgrades and enhancements. Upgrades and enhancements generally mean modifications to existing computer software that result in additional functionality (enabling the software to perform tasks that it was previously incapable of performing), or materially increase the speed or efficiency of the software.
- Planning the development of the computer software (or the upgrades and enhancements to such software), including identification and documentation of the software requirements
- Designing the computer software (or the upgrades and enhancements to such software);
- Building a model of the computer software (or the upgrades and enhancements to such software)
- Writing source code and converting it to machine-readable code;
- Testing the computer software (or the upgrades and enhancements to such software) and making necessary modifications to address defects identified during testing, but only until certain events occur
- Producing the product master(s) (if the computer software is developed for sale or licensing to others)
- The purchase and installation of purchased computer software, including the configuration of pre-coded parameters
- Any planning, designing, modeling, testing, or deployment activities with respect to the purchased computer software
- Training employees and other stakeholders that will use the computer software
- Maintenance activities after the computer software is placed in service that do not give rise to upgrades and enhancements (for example, corrective maintenance to debug, diagnose, and fix programming errors);
- Data conversion activities, except for activities to develop computer software that facilitate access to existing data or data conversion; and
- Installing the computer software and other activities relating to placing the computer software in service.
- Marketing and promotional activities
- Maintenance activities that do not give rise to upgrades and enhancements
- Distribution activities
- Customer-support activities
The IRS did acknowledge that the guidance provided in the Notice still may be limited when trying to apply IRC §174 R&E capitalization properly and asked for public comment regarding the utilization of an alternative software development definition under the Financial Accounting Standards Board Accounting Standards Codifications (ASCs) or an appropriate industry standard. In addition, the IRS requested comments for additional examples of costs that should not be considered software development. It is strongly encouraged for businesses in this space to provide commentary as requested by the IRS.
Existing §174 regulations provide that R&E expenditures include not only the costs paid or incurred by the taxpayer for research or experimentation undertaken directly by the taxpayer but also expenditures paid or incurred for R&E carried on their behalf by another person or organization. However, determining when a taxpayer is carrying on R&E expenditures on behalf of another person was not clearly defined.
The Notice provides that if a research provider bears financial risk under the contract terms with the research recipient, the costs paid or incurred by the research provider will be considered §174 R&E expenditures. Financial risk is the risk that the research provider may suffer a financial loss related to the failure of the research to produce the desired R&E product.
In addition, even if the research provider does not bear financial risk under the terms of the contract, if the research provider has a right to use any resulting R&E products in their trade or business or otherwise exploit any resulting R&E products through sale, lease, or license, then costs paid or incurred by the research provider will be considered §174 R&E expenditures to the provider.
Therefore, for a contract researcher not to be considered as incurring §174 R&E expenditures, the contractor must be able to document that they bear no financial risk and do not have the right to use, or otherwise exploit, any resulting R&E products through sale, lease, or license.
IRC §174 was modified for taxable years beginning after 2021, to disallow a deduction with respect to §174 R&E expenditures on account of disposition, retirement or abandonment but instead requires the taxpayer to continue capitalizing and amortizing those expenditures.
Unfortunately, at this time, the Notice seems to interpret the IRC language broadly. The Notice prohibits a corporation from deducting any remaining unamortized R&E expenditures unless the corporation ceases to exist. However, if a corporation ceases to exist due to an IRC §332 liquidation or identified IRC §368(a)(1) reorganization, the acquiring corporation will have to continue to amortize the distributor or transferor corporation’s unamortized R&E expenditures.
Based on current guidance, if a corporation contributes R&E property under an IRC 351 transaction or sells R&E property, the unamortized R&E expenditures are not included when computing taxable gain or loss. In addition, transfers of partnership property as part of a merger, consolidation, division, liquidation or termination would also not accelerate the deduction of IRC §174 capitalized costs.
While the IRS has only asked for comments regarding how the disposition, retirement, or abandonment of IRC §174 property in a partnership should be treated, it will most likely receive various comments regarding the overall guidance. Uncertainty still exists in instances where the IRC §174 R&E expenditures did not give rise to property that can be sold. In addition, denying the ability to reduce the gain on disposition due to expenses incurred for creating the §174 R&E property may be an overreach by the IRS. After all, nothing in IRC §174 overrides the general sale or exchange rules related to the disposition of property under IRC §1001.
And could the additional IRS guidance not be needed for the 2023 taxable year? We surely hope the Build It In America Act (HR 3938), or portions of the proposal, can be passed by the end of the year. The Act delays the IRC §174 R&E capitalization requirement until the taxable year starting after December 31, 2025. Even though Congress may have recently provided bi-partisan legislation by passing the continuing resolution to keep the government funded through November 17th, it is unclear whether similar bi-partisan legislation can be passed in order to retain and support continued R&E practices in the United States.
And even though the Act would only extend §174 immediate expensing through 2025, it gives companies a longer runway to plan accordingly. Under the Tax Cuts and Jobs Act (“TCJA”), many professionals (including myself) thought that U.S. policy would never penalize businesses conducting R&E in the U.S., but it’s clear that anything is possible. Planning and advocating Congressional leaders for IRC §174 immediate expensing should continue to be a top priority for all businesses conducting R&E. Even more of the TCJA provisions expire in 2026, including the elimination of the pass-through (199A) deduction and an increase in the top individual income tax rates to 39.6%. If the capitalization of IRC §174 research and experimental expenditures is also pushed to 2026, the stage will be set for significant federal income tax reform.