Businesses Face Challenges with New Research & Development Tax Rules

IRS provides guidance on specified research and experimental expenditures

Research and development (R&D) costs are an important part of business operations, as they support innovation, process improvements, competition, and profitability.

Overview of R&D Tax Rule Changes

Prior to the 2017 Tax Cuts and Jobs Act (TCJA), businesses had the option to either deduct their R&D costs in the year they were paid or incurred or capitalize and amortize them over a period of at least 60 months. This provided flexibility and tax benefits, as businesses could choose the method that was best suited for cash flow and profitability. Additionally, businesses that deducted R&D costs could also claim the R&D tax credit under Section 41 of the tax code, which provided an incentive for investing in qualified research activities.

The tax treatment of R&D costs has changed significantly due to the TCJA, which affected how businesses account for and deduct these costs. In our article, 2022 R&D Tax Deduction Changes, we detailed the changes that took effect January 1, 2022. A recent article in the Wall Street Journal, highlights how the changes have impacted the largest U.S. public companies as well as smaller businesses in the areas of increased tax liability, job losses, and reduction in R&D investments.

Interim Guidance on Specified Research and Experimental (SRE) Expenditures

In September 2023, the Internal Revenue Service (IRS) issued Notice 2023-63, which announced the IRS’s intent to issue proposed regulations addressing items related to Section 174 as amended by the TCJA. The Notice provides long awaited guidance for businesses regarding amortization of specified research or experimental expenditures. Following are the key areas covered in the guidance:

• Capitalization and amortization of SRE expenditures

  The notice provides taxpayers with clarity regarding the requirement in Sec. 174(a) to capitalize and amortize SRE expenditures and the treatment of short tax years. For example, the term “midpoint” means the first day of the seventh month of the tax year in which the SRE expenditures are paid or incurred, except for short tax years.

• Scope of Sec. 174

  The notice provides clarity in determining whether expenditures are SRE expenditures subject to capitalization and amortization under Sec. 174. For example, costs of labor, patents, and materials and supplies for research are covered as SRE expenditures, while costs to register an internet domain, website hosting, or interest on debt to finance SRE activities are not.  In addition, guidance is provided on allocation of costs to determine SRE expenditures.

• Software development

  The notice provides taxpayers with clarity in determining whether certain activities constitute software development for purposes of Sec. 174(c)(3), which includes planning the development of the software, designing the software, and writing source code.

• Research provided under contract

  The notice provides taxpayers with clarity in determining whether costs paid or incurred for research performed under contract are SRE expenditures under Sec. 174.

• Disposition, retirement, or abandonment of property

  The notice clarifies how to treat unamortized SRE expenditures if the property is disposed of, retired, or abandoned in certain transactions.

• Long-term contracts under Sec. 460

  The notice provides information about a proposed revision to Sec. 460 in upcoming proposed regulations about how to apply the percentage-of-completion method to account for income from long-term contracts when allocable contract costs include SRE expenditures.

• Cost-sharing regulations at Regs. Sec. 1.482-7

  The notice gives information about a proposed revision to Regs. Sec. 1.482-7(j)(3)(i), which addresses cost-sharing transaction payments between participants in certain cost-sharing arrangements.

The guidance in the Notice would apply for taxable years ending after September 8, 2023. A business may choose to rely on the rules described in the notice, including for expenditures paid or incurred in tax years beginning after December 31, 2021, provided the taxpayer relies on the rules and applies them in a consistent manner.

The guidance does not apply when determining whether an expenditure paid or incurred for tax years beginning before January 1, 2022, is a research or experimental expenditure under Sec. 174 as in effect for tax years beginning before January 1, 2022.

Outlook for R&D tax law

The changes to the tax treatment of R&D costs under the TCJA have significant implications for businesses that engage in R&D and software development activities. There is bipartisan support to change the tax law; however, it is unlikely anything will pass soon with the upcoming 2024 election.

Businesses should consult with their tax advisors and accountants to understand how the new rules affect their tax liability and financial statements, and to plan accordingly for the upcoming tax years. The Keiter Tax team is closely monitoring R&D tax regulation changes and will keep you updated.

Questions specific to your business’s R&D tax liability? Contact your Keiter Opportunity Advisor.

Sources:

• The Tax Adviser – Long-awaited guidance provided for amortization of R&E expenditures – September 11, 2023
• The Wall Street Journal – CFO Journal – A Tax Rule Change Is Threatening the Survival of Some Businesses – October 24, 2023