Section 174 Amortization Updates

The IRS issued Revenue Procedure 2023-8 on December 12th to modify the change in accounting method procedures for taxpayers complying with the Section 174 law change. As background, the Tax Cuts and Jobs Act (TCJA) included a law change requiring taxpayers to amortize Section 174 research and experimental (R&E) costs over a five-year period for tax years beginning after December 31, 2021. R&E costs were currently deductible prior to December 31, 2021. Please see a comprehensive analysis regarding the change to the income tax treatment of Section 174 costs.

Revenue Procedure 2023-8 provides guidance to taxpayers who are amortizing R&E costs to comply with the law stating they will not have to file a Form 3115 Change in Accounting Method form. Instead, taxpayers will need to include a statement with their originally filed income tax return for the first taxable year of the law change. This statement must include the name and EIN or social security number of the applicant that has paid the R&E costs after December 31, 2021, the beginning and ending dates of the first taxable year in which the change to the required Section 174 method take effect for the applicant, the designated automatic method change number for this change, a description of the type of expenditures included as R&E costs, the amount of R&E costs incurred by the taxpayer during the year of change, and a declaration that the applicant is changing the method of accounting to amortize the R&E costs in accordance with the TJCA law change. However, a Form 3115 will be required if a taxpayer makes a change of accounting method for Section 174 after the first taxable year of the Section 174 law change.

We, like many other practitioners, continue to hope the Section 174 amortization requirement may be delayed or repealed. It is unclear whether the current Congress will take any action on this issue prior to December 31, 2022. Based on the current political climate, it is more likely that corrective legislative action for the 2022 tax year, if any, occurs in January or February 2023 after the new Congress has been sworn in. We will continue to monitor this situation and update our clients as new information becomes available. Please reach out to us if you have questions.

While taxpayers have enjoyed a variety of tax benefits from the 2017 Tax Cuts and Jobs Act (TCJA) such as the lowered corporate tax rate, this bill came with an eventual cost to companies that conduct research: The requirement to capitalize and amortize IRC Section 174 research costs over a 5-year period for tax years beginning after 12/31/2021. The 174-amortization provision was used as a “revenue raiser” to help balance the other tax breaks within the bill and many legislators at the time indicated that they would work to repeal this requirement before it came into effect. While there have been several bills proposed that delay or repeal the 174-amortization requirement over the last couple of years, none have survived. With mid-term elections approaching in early November, a solution is not likely until mid-November at the earliest as Congress seeks to fund the government past December 16.

Taxpayers are now left wondering if and when this issue will be addressed and resolved. This includes any taxpayers claiming the Section 41 R&D Credit, as all costs identified as Section 41 expenses must also be classified under Section 174. Any costs claimed as qualified research expenses for Section 41 purposes will have to be amortized rather than expensed, and the 174 costs will likely be larger since the costs includable in Section 174 are more expansive than Section 41.

Because the 174-amortization requirement will result in a large tax increase for companies conducting research, taxpayers may wonder whether they should forego the R&D Credit and fully deduct all of their expenses for the current year. While that approach is tempting, it isn’t an option for taxpayers incurring 174 expenses – especially for taxpayers with a history of identifying 174 research expenses and annually claiming the Section 41 R&D credit. Research expenses incurred in tax year 2022 and forward must be amortized even if a taxpayer decides to not claim the Section 41 R&D Credit.

If the law remains unchanged, the IRS will look toward enforcing 174-amortization. Because the TJCA added in the 174-amortization provision as a method to raise revenue, the IRS will want to ensure that these requirements are followed in order to collect the additional projected tax. Additionally, a large portion of the IRS’s $80 billion in additional funding from the Inflation Reduction Act is earmarked for compliance and enforcement, which may include examining taxpayers who conduct research to ensure they are following the 174-amortization requirement in the event it is not delayed or repealed. For those taxpayers with a history of claiming the R&D Credit, ignoring the amortization requirement for immediate expensing comes at the cost of increased examination exposure as well as the inability to claim the R&D Credit.

Until this is resolved, taxpayers must prepare for the upcoming 2022 tax filing season as if there will be no change to the current law. Because the tax code and regulations do not define various categories of expenditures for 174, taxpayers and their advisors will have to carefully analyze the various costs incurred by the business for the 2022 tax year to ensure they are following the 174-amortization requirement. This may include isolating costs that would strictly be classified as 174, and then making estimated tax payments based on those amounts. Additionally, if this does not get resolved before the end of 2022, taxpayers may want to extend their returns to see if Congress takes action in early 2023. Ultimately, taxpayers should be prepared but remain flexible and patient as they head into the 2022 tax filing season.