Many were hopeful for U.S. tax legislation ensuring businesses could continue to fully deduct their research and experimental (“R&E”) expenditures in the 2022 taxable year. Senator Margaret Hassan (D-NH) introduced a bill as recently as March 16, 2023, to provide an immediate deduction related to Section 174 expenditures. However, the partisan Congressional divide will likely force businesses to reduce 2022 Section 174 R&E deductions to as little as 10% for domestic and 3.3% for foreign research.
Such a significant decrease in deductible expense is staggering compared to other countries, including China which provides a deduction 20 times higher than the U.S., or a 200% deduction, for R&E expenditures. While there is a strong disdain for Congress due to the lack of legislation, tax professionals and businesses are forced to gain a better understanding of the tax law surrounding Section 174 R&E expenditures and strive to strike a balance of practical application versus an overwhelming administrative burden. Unfortunately, the devil is in the details and may catch many taxpayers by surprise.
Surprise #1: Section 174 R&E Expenditures Are Not the Same Expenditures Evaluated for the Section 41 Research Credit
A reasonable assumption would be to review a business’s qualified research expenditures (“QREs”) under Section 41 and apply the capitalization policy under Section 174. However, this most likely would result in a gross understatement of Section 174 expenditures that must be capitalized. While it is true a Section 41 QRE must be included as a Section 174 capitalized expenditure, many more expenses could be captured under Section 174. Section 174 casts a much broader net and specifically includes pilot models and costs of obtaining a patent, neither of which are Section 41 QREs. Also, while Section 41 QREs only include 65% of contract research expenses, Section 174 provides that all contract research expenses are capitalized. Lastly, the definition of Section 174 expenditures include all such costs incidental to the development or improvement of a product. Therefore, indirect costs that are incidental to research must be included. Common examples include employee benefits, indirect labor costs, utilities, depreciation, and rent.
While the research credit is limited to direct research labor, supplies, and 65% of contract research, R&E expenditures under Section 174 are far more expansive, requiring a detailed analysis of a business’s trial balance to ensure the appropriate expenditures are captured.
Surprise #2: Internal & External Software Development Costs Need To Be Included
This surprise, and lack of guidance, has left many software developers scratching their heads. For purposes of the Section 41 research credit, software must be developed primarily for external use. However, Section 174 expenditures include any amount paid in connection with the development of software, whether for internal or external use. While Revenue Procedure 2000-50 provides guidance on the definition of software for Section 174, there is no definition of development under Section 174.
Under Rev. Procedure 2000-50, computer software is defined as any program or routine designed to cause a computer to perform a desired function or set of functions, and the documentation required to describe and maintain that program or routine. Computer programs of all classes, including operating systems, executive systems, monitors, compilers and translators, assembly routines, utility programs, and application programs, are considered software.
While many taxpayers can clearly identify software, whether they are developing software is a gray area. Section 174 expenditures activities are intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Court cases have provided some guidance when trying to understand “uncertainty” in the context of software development. The following questions should be discussed with your advisors to properly categorize Section 174 expenditures.
- Do the developers know exactly what steps to follow to create or design the product? Or is the development trial and error?
- Do the developers use proprietary software or software widely used?
- Do the developers utilize open-source software, or are they writing code from a blank slate?
Surprise #3: A Section 280C Election Is Probably Not Advantageous (Keep Reading!!)
Before January 1, 2022, many companies would make a 280C election for simplicity of adjusting taxable income for the research credit claimed. Without a 280C election, the amount of research credit reduced the amount of qualified research expenditures generating tax deductions when calculating taxable income. This requirement was burdensome and could cause headaches when filing state income tax returns. Alternatively, taxpayers could elect the 280C election, which allowed taxpayers to reduce the amount of the research credit by the tax effect of the credit. For a simplistic example, assume that a corporation had $1,000,000 of qualified research expenditures that generated a research credit of $200,000. By making a 280C(c) election, the corporation would not be required to reduce the amount of allowable tax deductions to $800,000 (1,000,000-200,000) and instead reduce the amount of the research credit claimed to $158,000 (200,000 – (200,000 x 21%)). Taxpayers would often choose to make a 280C election in relation to either an actual research credit for the taxable year or a protective election in the event a research credit was claimed in the future.
However, for taxable years starting after December 31, 2021, the TCJA language modifications of Section 280C will most likely make the 280C election unnecessary, and potentially result in a negative impact on cash flow if an election is made.
Under Section 280C(c)(2) the law was amended to state:
If the amount of the research credit 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 is reduced by the amount of such excess.
To summarize the amendment, if the amount of the research credit does not exceed the amount of the Section 174 R&E deduction for the current taxable year, no adjustment is made to the research credit, the allowable Section 174 R&E deduction, or the Section 174 capitalized asset. In the unusual event that the amount of the research credit exceeds the amount of the current year Section 174 R&E deduction, there would still be no adjustment to the research credit or current year Section 174 R&E deduction. However, the remaining capitalized asset after the current year deduction would be decreased for the excess amount of the research credit over the current year 174 R&E deduction.
Let’s highlight this important concept in an example. Assume Corporation X identified $1,200,000 of Section 174 expenditures. The amount of the current year Section 174 deduction would be $120,000 (1,200,000/5 *1/2), leaving a capitalized asset of $1,080,000 on the tax basis balance sheet. In the same year, a research credit of $100,000 was calculated. As the research credit of $100,000 was less than the amount of the current year Section 174 deduction of $120,000, no adjustment is required to either the research credit, the current year 174 deduction, or the Section 174 capitalized asset recorded. However, if a Section 280C election were made, the research credit applied to the current year’s tax liability would no longer be $100,000 but $79,000 (100,000-(100,000 x 21%). The checking of one little box in our example would require the taxpayer to pay an additional $21,000 in tax.
If there is only one thing you take away from this article, be cautious when making the 280C election. This concept also applies to the protective 280C elections. Once a 280C election is made for a taxable year, it is irrevocable.
Surprise #4: Section 174 Contract Research Application Is Contrary to the Section 41 Credit Application
For the research credit, if a company contracts out research to a commonly controlled entity, the commonly controlled entity will be deemed as performing the research, and potentially avail themselves of the research credit. The intercompany transaction between the entities involved in the contract will be ignored for research credit purposes.
For Section 174 purposes, the opposite holds true. If a company contracts out research to a commonly controlled entity, the company making the contract will be deemed the entity with the Section 174 expenditure, and not the contractor. Section 174 expenditures include research or experimentation undertaken directly by the taxpayer and expenditures paid or incurred for research or experimentation carried on his behalf by another person or organization (such as a research institute, foundation, engineering company, or similar contractor).
If a U.S. parent contracts out research to a wholly owned foreign subsidiary, and it is confirmed that the foreign subsidiary was not performing the research under its own orders or risks and the product developed could be used in the U.S. Parent’s trade or business, then the U.S. Parent will be deemed as having a Section 174 expenditure related to the research activities. The amount required to be capitalized at the U.S. Parent level is most likely higher than the actual research costs incurred at the foreign subsidiary, as the U.S. Parent most likely has a cost-plus arrangement with the subsidiary. In addition, as the research was performed outside the U.S., the U.S. Parent will be required to capitalize the Section 174 expenditures over a 15-year period.
Alternatively, the foreign subsidiary can take an ordinary trade or business expense in relation to the research expenditures when calculating earnings and profits. Unfortunately, in this particular example, the foreign subsidiary will be deemed the researcher for the research credit and cannot utilize the expenditure when calculating the research credit.
Surprise #5: A Form 3115 Is Not Required for the 2022 Taxable Year
And it is nice to end with a good surprise! While the language in the TCJA provides for an automatic accounting method change, Form 3115 will not be required in the first taxable year Section 174 capitalization becomes effective. The IRS issued Revenue Procedure 2023-11 (which amended Rev. Proc. 2023-8), which allows a taxpayer to obtain consent to change the accounting method for specified research or experimental expenditures to comply with IRC Section 174 simply by filing a statement with the original taxpayer’s Federal Income tax return. A Form 3115 will be required in future years.
The statement must include the following information for each applicant:
- The name and employer identification number or social security number, as applicable, of the applicant that has paid or incurred specified research and experimental expenditures after December 31, 2021;
- The beginning and ending dates of the first taxable year in which the change to the required Section 174 method takes effect for the applicant (year of change);
- The designated automatic accounting method change number for this change;
- A description of the type of expenditures included as specified research or experimental expenditures;
- The amount of specified research or experimental expenditures paid or incurred by the applicant during the year of change; and
- A declaration that the applicant is changing the method of accounting for specified research or experimental expenditures to capitalize such expenditures to a specified research or experimental capital account, and amortize such amount over either a 5-year period for domestic research or 15-year period for foreign research (as applicable) beginning with the mid-point of the taxable year in which such expenditures are paid or incurred in accordance with the method permitted under Section 174 for the year of change. Also, the declaration must state that the applicant is making the change on a cut-off basis.
Unfortunately, a significant amount of information must be digested for Section 174 R&E capitalization. There is limited guidance, and the rules oftentimes do not follow the same logic as the research credit. To say taxpayers are frustrated with the requirement to capitalize Section 174 R&E is an understatement. After all, isn’t the U.S. viewed as the land of innovation? But now, innovative businesses in the U.S. are feeling penalized in comparison to their counterparts overseas. And even when businesses are trying to comply, the lack of guidance surrounding the requirement can be overwhelming.
I will end with a brief PSA announcement. Be nice to your tax professionals. As you may be aware, tax professionals cannot sign a return without having substantial authority, and the current tax law is quite clear. Section 174 capitalization is required for the 2022 taxable year, and therefore, both taxpayers and tax professionals are stuck with doing their best to apply the existing law and report the impact properly on the income tax return. The only way to circumvent Section 174 capitalization is for Congress to amend the law. Let’s just hope that Congress will act soon and ensure the U.S. can remain a leader in research and innovation.
For more information on this topic, please contact a member of Withum’s Business Tax Services Team.