The Tax Cuts and Jobs Act of 2017 (TCJA) requires capitalization of all specified research and experimental expenditures (SR&E) incurred in tax years beginning after December 31, 2021. On September 8, 2023, the IRS released Notice 2023-63 notifying taxpayers of their intent to issue proposed regulations under Section 174. As stated in the Notice, taxpayers may rely on the guidance in the Notice for tax years beginning after December 31, 2021, if they apply the notice in full.
Historical Treatment of R&D Expenditures
Since 1954, the U.S. tax code gave businesses the option of deducting research and development (typically referred to as “R&D”) expenditures either in the same taxable year in which they occur or amortized over a period of at least 60 months.
New Rules under TCJA
Starting in 2022, the U.S. tax code will no longer allow businesses to expense all qualified Internal Revenue Code (IRC) Section 174 expenditures in the year they are incurred. Instead, taxpayers will be required to amortize any such deductions over 5 years for domestic expenditures or over 15 years for expenses incurred offshore. To determine whether SR&E costs are attributable to foreign research, taxpayers must look to where they (or their service provider) physically perform the research and experimental activities. Capitalization and amortization period would begin with the midpoint of the tax year in which the expenditures are paid or incurred. Taxpayers will also be required to amortize SR&E expenditures for the 5 or 15 year period even if the related property is disposed of, retired, or abandoned during the amortization period. The disposition, retirement or abandonment does not accelerate the expense deduction.
To properly comply with IRC Section 174, taxpayers must be able to identify all SR&E expenditures, which Treasury Regulations and Notice 2023-63 broadly define as expenditures incurred in connection with the taxpayer’s trade or business which represent research and development expenditures in the experimental or laboratory sense. The term generally includes all costs incident to the development or improvement of a product. Expenditures represent SR&E costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not ascertain the capability, method for developing, or the appropriate design of a product. Whether expenditures qualify as SR&E expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents. The success, failure, sale, or use of the product is not relevant in determining eligibility under IRC Section 174. Further, costs may be eligible if paid or incurred after production begins but before uncertainty is eliminated.
Internal Revenue Code Section 174 and Notice 2023-63 define SR&E to include (but not limited to):
- All software development costs
- Labor costs include the cost of full time, part-time, and contract employees who perform, supervise, or directly support SR&E activities. This cost includes all elements of compensation (including stock-based compensation) other than severance costs.
- Material and supplies including tools and equipment which are used or consumed to conduct SR&E activities or in the direct support of.
- Contract research paid by a taxpayer to a service provider falls within the scope of Section 174. The Notice clarifies that cost paid or incurred by a research provider may be treated as SR&E expenditures if (1) the research provider bears financials risk under the terms of the contract with the research recipient, or (2) the research provider has a right to use any resulting SR&E product in its trade or business or to otherwise exploit any resulting SR&E product through sale, lease, or license.
- Long-term contracts under Section 460 and the interaction between Section 174 are addressed in the Notice. Under the Notice, taxpayers are only required to include the amount of allowable amortization as a contract cost incurred during the year and not the entire amount of capitalized Section 174 costs incurred.
- Indirect research costs such as overhead and administration costs (rent, utilities, depreciation, payroll taxes, benefits, etc.)
- Cost of obtaining a patent such as attorney fees
- Travel costs if they are incurred to perform SR&E or the direct support of SR&E
- Testing products (not including ordinary QC)
- Developing and designing products/systems
- Improving products/systems
- Developing prototypes
- Validation testing
- Research after commercial production
- Research related to style, taste, cosmetic, or seasonal design factors
- Adaption of existing product to a particular customer’s need
- Reverse engineering
Notice 2023-63 specifically excludes certain costs from the definition of SR&E:
- General and administrative costs that only indirectly support or benefit SR&E
- Software testing after it is placed in service or is ready for sale or licensing
- Interest on debt to finance SR&E
- Costs paid to input content into a website
- Costs for web hosting
- Costs to register a domain name or trademark
Capitalizing SR&E expenditures that have previously been allowed as tax deductions may put many companies in a taxable income position and create tax liabilities. However, with proper planning and documentation of SR&E activities, taxpayers may be able to offset taxable income with R&D tax credits.
Since Congress did not take any action before the 2022 tax return filing deadline, it is essential that companies establish reasonable documented positions for their tax return filings. Start by developing a process to identify and track SR&E expenditures (as defined under IRC Section 174) and separating them from other deductible expenses, possibly by using a departmental profit and loss method to track such costs. Taxpayers will no longer be able to aggregate SR&E expenditures with other items that can be expensed (such as sales, general, and administrative expenses). This will likely be a significant undertaking for taxpayers to comply with the TCJA changes based on the broad and subjective nature of these provisions.
Please contact us if you would like to understand the tax implications of this change and discuss your eligibility to claim R&D tax credits.
Aura Advisors, an Accountancy Corporation is a boutique tax consulting, compliance, and representation firm working with start-up/emerging growth companies and affluent individuals. Building connections beyond the code.