Tax Credits

Changes to R&D Expensing rules: What accountants need to know

Accountants across the US are about to experience an income tax season that could threaten business survival because of new research and experimentation expenditure treatment under Section 174. Deborah Roth, CPA at Source Advisors explains changes to Section 174 for taxpayers.

What is Section 174?

In 2017, Congress passed the Tax Cuts and Jobs Act (TCJA) and, among other things, changed the treatment of Section 174 “specified research and experimental” (SRE) expenditures and software development expenditures. This change did not go into effect until 2022; for tax years beginning in 2022 and afterward, section 174 SRE expenditures are required to be capitalised and amortised over five years (fifteen years for foreign research). Prior to the change, taxpayers were given the option to deduct the expenditures in the current year or capitalise and amortise these expenditures.

Deborah Roth, CPA, Source Advisors

How are taxpayers impacted by these changes?

Section 174 affects the timing of SRE expenditures, requiring them to be capitalised and amortised. This loss of immediate deductions creates additional tax liability for many taxpayers in the short term. However, due to the timing difference with the amortisation, the taxes even out over the long term.

Accountants should pay attention to how these expenditures are being handled as failure to adequately account for § 174 expenditures is a compliance risk that could yield penalties and interest. It is very possible that the IRS could create a compliance campaign on this issue in the future. Further, § 41 is essentially a subset of § 174, which means § 174 is broader than the definition of research expenditures under § 41.

What happens if no action is taken?

If no action is taken, the impact on business cashflow could be detrimental. As mentioned earlier, the requirement to capitalise and amortise the expenses is a timing difference. Whereas there are increased taxes in the short term, in the long term the timing difference evens out. On the other hand, the R&D tax credit is a permanent part of the tax code and typically provides immediate benefit to the taxpayer. Failure to claim the Section 41 R&D tax credit could cost taxpayers up to $85,000 for every $1M in R&D expenditures annually.

Which industries are being impacted the most by Section 174?

While § 174 will affect all industries and companies that perform research, the software industry appears to be taking the biggest hit as the TCJA specifically called out software development expenditures. 

The IRS published Notice 2023-63 earlier this year to provide guidance on how the new capitalisation rules under Section 174 should be applied to taxpayers. The Notice indicates that taxpayers are required to capitalise certain expenditures related to the development of new software programs, as well as certain enhancements to existing software where the enhancements result in additional functionality or increased efficiency. The Notice also states that expenditures from activities such as planning software development, documenting software requirements, designing and building models of computer software, and writing code are all subject to the new capitalisation rules. However, taxpayers are not required to capitalise any expenditures incurred after the computer software is ready for sale or license to others, such as expenditures related to marketing, distribution, or customer support. 

What other industries are likely to be affected?

Because SRE expenditures are not industry-specific, all industries are potentially impacted. Manufacturing companies, engineering firms, and pharmaceutical industries are just some of the industries that typically have large research and development efforts annually.

How can accounting teams manage the impact of the changes?

First, it’s important to understand the nature of your client’s business. If they are developing a product or software, there will likely be Section 174 expenditures to account for.  

The items below are not exhaustive but cover some of the more common expenditures: 

  • Labor costs (full-time, part-time, contract employees, and independent contractors), including all elements of compensation except severance pay; 
  • Material and supply costs; 
  • Depreciation, amortisation or depletion allowances for assets used in SRE activities; 
  • Patent costs; 
  • Certain operation and management costs (rent, utilities, etc.); 
  • Certain operational and travel costs.

 Next, taxpayers who think their activities may fall under § 174 should document all activities and expenses related to their SRE expenditures and work with their tax advisors to determine whether their expenses must be capitalised. If the accountant is not comfortable with the application of the new rules, seek out a specialist.  

Finally, take action! Determine the best path forward to address the uncertainties from Section 174 and also claim any associated Section 41 R&D tax credit benefits in the process. The Section 41 R&D credit is one of the few incentives that offsets the increased taxes from Section 174.

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