In Brief
- Based on IRS Notice (2023-63), companies might not be capturing all costs for 174
- 174 costs includes Overhead Labor, Depreciation allowance, and others.
- 174 deduction excludes costs from Administrative Departments.
A lot of companies had their first introduction filing the 174 R&D deduction (“174”) this past year. If a company had software development or wanted to claim the R&D Credit, they did not have a choice. The Tax Cuts and Jobs Act required all taxpayers with research expenses to capitalize and amortize these expenses over a 5- or 15-year period, depending on whether the expenses were domestic or foreign.
Although the 174 deduction is intricately connected with the R&D credit, what qualifies for the 174 deduction is broader, both in qualification and the scope of expenses. As with the R&D Credit, there is a level of judgement needed to determine what activities should be qualified under the 174 deduction. Initially there was a surprise in the level of unambiguity about which expenses should be included.
The Internal Revenue Service stepped in to help and gave some much-needed guidance (Notice 2023-63) on many things surrounding the 174 deduction, one of which was the scope of expense to include. From the IRS notice, they helped specify which 174 costs should and should not be included. The notice categorizes expenses that are “incident to the development or improvement of a product, a component of a product, or subcomponent of a product,” which is a key definition found in the R&D deduction regulation.
Based on the guidance the IRS gave, in the initial year most companies did not capture all the expenses for the 174 deduction. This will most likely lead to adjustment in the next year to the scope of expenses included for the 174 deduction. Also, this article does not cover software development, which is also included in the notice and required to be included under 174.
R&D Deduction Cost Categories
Any company that has research activities needs to review and make sure they examine whether they had any of the expense categories the IRS specified. Here are categories the IRS wants companies to review and add to their R&D deduction expenses:
Overhead Labor Costs:
In addition to wages, companies need to pick up all elements of compensation including stock-based compensation, overtime pay, vacation pay, holiday pay, sick leave pay, payroll taxes, pension costs, employee benefits, and payments to a supplemental unemployment benefit plan. A surprise is companies do not have to account for severance compensation. Yet, aside from this exception, companies should include all fringe benefits expenses that are attributed to qualified employees.
Overhead Materials and Supply Costs:
If there were materials and supplies, including tools and equipment that were used and consumed in qualified activities these should be part of the 174 expenses. Similar to the R&D Credit, these should be only tangible items, software or software licenses would be excluded. Software is included in 174 but addressed separately in the notice and not addressed in this article.
Cost Recovery Allowances:
This would be property that is depreciated and amortized for a company. It should only be depreciated property that was necessary in qualified activity. The notice gave the example of a “test bed” for research as property costs that should be included.
Patent Cost:
These costs connected with obtaining a patent, such as attorneys’ fees expended in making a patent application.
Travel:
Any travel expenses related to the direct involvement or support of qualified activities.
Operational Costs:
Certain operation or management expenses should be included, including costs that were a part of maintaining facilities and equipment used for qualified activities. The IRS notice highlights rent, utilities, insurance, taxes, repairs and maintenance and security costs as expenses that fit into the category.
Excluded R&D Deduction Costs
The IRS does make clear certain types of expenses that should be excluded, which provides clarity for 174.
In the notice, the IRS stated any costs from general or administrative departments should not be treated as 174 expenses. There are many departments that only indirectly support or benefit qualified activities. Payroll, Human Resources, and Accounting were all departments called out as excluded in the notice. This gives companies an important boundary around qualified expenses. Not all expenses that could relate to qualified activities are qualified expenses. There is a clear fence that stops administrative departments from being included in R&D deduction. The notice also excludes debt interest, software costs after development and website content costs as also excluded from 174.
Some more guidance?
Although this notice is welcomed, companies should be aware more could be coming. The IRS stated companies should have confidence with their areas in which they clarified, but more clarification—and possible expansion to expenses—could be given. Yet with this new guidance from the IRS, companies should have a better understanding as to what expenses should be in their 174 deductions, and most importantly, what should not. The expenses that should be included might be more than companies initially thought, but it is important to note that there were also limits given on the scope of 174 expenses.
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