THE NEW 174 METHOD CHANGE
On December 12, 2022,the IRS released Rev. Proc. 2023-8 containing long-awaited procedural guidance concerning the 2017 amendment to Section 174, which requires the capitalization and amortization of specified research or experimental (R&E) expenditures paid or incurred in taxable years beginning after December 31, 2021.
The Tax Cuts and Jobs Act (TCJA) amended section 174 of the Code to require capitalization of specified research and experimental (R&E) expenses (new section 174). Under new section 174, specified R&E expenses must be capitalized and amortized over the applicable period (5 years for domestic research and 15 years for foreign research), beginning in the year the expenses are paid or incurred. Further, software development costs are treated as specified R&E expenses. This treatment is in stark contrast to the favorable treatment provided prior to amendments by the TCJA in which a taxpayer could deduct its R&E expenses and software development costs. New section 174 applies to specified R&E expenses paid or incurred in taxable years beginning after 2021.
A taxpayer requesting a method change to apply new section 174 is granted limited audit protection; under this rule, no audit protection is granted for R&E expenses paid or incurred in taxable years beginning before 2022. Further, notwithstanding the general audit protection rules under Rev. Proc. 2015-13, the IRS may change the characterization or classification of a taxpayer’s expenditures as specified R&E expenditures.
The release of this procedural guidance and that this newsletter is released with only a few days left in 2022, is a strong indication that the TCJA changes to section 174 are here to stay. Rev. Proc. 2023-8 provides taxpayers the roadmap to change their existing methods of accounting for R&E costs to the new section 174.
Scope of Rev. Proc. 2023-8
Rev. Proc. 2023-8 modifies the list of automatic method changes provided in Rev. Proc. 2022-14 to include a new automatic method change under section 7.02 of Rev. Proc. 2022-14 for a change to apply the capitalization and amortization rules under new section 174.
The automatic method change provided by Rev. Proc. 2023-8 only applies to specified R&E expenses paid or incurred in taxable years beginning after 2021 and includes different procedures depending on whether a taxpayer is requesting a change for their first taxable year beginning after 2021 or for a subsequent year.
Highlights of Rev. Proc. 2023-8 are as follows:
1. Grant of automatic consent
Taxpayers may use this new automatic accounting method change procedure to secure the IRS consent necessary to change from their present Section 174 accounting methods to the new capitalization and amortization regime.
2. Statement in lieu of Form 3115 for changes made in the first effective year
For changes made in the first taxable year beginning after December 31, 2021, the revenue procedure waives the requirement to file a Form 3115, “Application for Change in Accounting Method”. Instead, taxpayers request and implement the change by attaching a statement to their original federal income tax return. The statement must contain the following information for each applicant:
- The name and EIN (or SSN) of the applicant that has paid or incurred R&E costs after December 31, 2021;
- The beginning and ending dates of the year of change (the first taxable year in which the change to the required Section 174 method takes effect for the applicant);
- The designated automatic accounting method change number (DCN 265);
- A description of the type of expenditures included as R&E costs;
- The amount of R&E costs paid or incurred by the applicant during the year of change; and
- A statement that the applicant is changing the method of accounting for specified R&E expenditures on a cut-off basis. The applicant must also state that under the new method they will capitalize such expenses to a specified R&E capital account and amortize it over a 5-year or 15-year period, as applicable, beginning with the mid-point of the taxable year in which the expenses were paid or incurred.
3. Delayed changes require a Form 3115 and modified Section 481(a) adjustment
When the change is made for years later than the first taxable year beginning after December 31, 2021, the requirement to file a Form 3115 to secure the necessary consent is not waived.
For these delayed changes, the revenue procedure requires a modified Section 481(a) adjustment, which would consider only those R&E costs paid or incurred in taxable years beginning after December 31, 2021.
This modified Section 481(a) rule serves to reduce the opportunity for strategic delay in implementing the new regime. As an example, if an accrual basis taxpayer continues to immediately expense its domestic R&E costs in accordance with its historic method, deducting $200,000 that it had incurred during the 2022 tax year, that taxpayer would have a $180,000 unfavorable Section 481(a) adjustment were it to request this accounting method change for the 2023 taxable year (the original $200,000 expense, less the first year amortization based on the midpoint approach, calculated as of the beginning of the 2023 year of change).
4. Favorable transition rule
For taxpayers who have already filed 2022 tax returns (or who do so prior to January 9, 2023), the revenue procedure deems such taxpayers to have effectively changed their methods of accounting as long as the taxpayer (i) properly capitalized and amortized its R&E costs in accordance with the new rules, and (ii) properly reported its R&E costs incurred on Part VI of Form 4562, Depreciation and Amortization.
5. Waiver of eligibility rule
Limited to changes made in the first post-2021 year, the revenue procedure waives the general rule prohibiting a taxpayer’s use of automatic consent procedures for subsequent changes sought on the same item within a five-year window.
Taxpayers who have changed their R&E cost method within the last five years (perhaps with the aim of maximizing deductions prior to the amendment’s effective date) should note of the limitation on this waiver. If such taxpayers do not change to the new rules for their first tax year beginning after December 31, 2021, they will be scoped out of the automatic change procedures until that five-year window has lapsed. Taxpayers scoped out of Rev. Proc. 2023-8 will need to file their accounting method changes to comply with the Section 174 amendment under the more burdensome and costly advance consent procedures.
However, taxpayers should keep in mind that they will not receive audit protection for R&E costs (including software development costs) paid or incurred in taxable years beginning before 2022. Further, while the IRS waived the general prior five-year scope limitation, this waiver only applies to changes made for the first taxable year beginning after 2021. Thus, taxpayers that filed one or more method changes for R&E expenses or software development costs for years beginning before 2022 may be unable to file an automatic method change to apply the new section 174 rules if such taxpayers fail to make the change for their first tax year beginning after 2021.
Decreasing Deductions and Increasing Taxable Income
These changes will mostly affect taxpayers who claim the Research and Development Credit by decreasing the amount of deductions available via 174, and thereby increasing taxable income – especially for software companies which utilize overseas development activities. In some situations, this increase may be significant, along the lines of a 50% increase, or taking a taxpayer from a net loss to a net profit position.
Taxpayers need to know that going forward, additional information will need to be gathered that they were priorly not used to gathering for the Research and Development Credit. These data include development costs incurred outside of the United States, and data that can be delineated between design, construction, and testing phases of research. By breaking out expenses in these ways, taxpayers might be able to claim some expenses as qualified research expenses (QRE) – which will then need to be capitalized and amortized – and others as cost of goods sold, to increase deductions.
Additional items to consider are that qualified expenses are treated differently under section 174 than they are in section 41 – namely, that there are no provisions for “substantially all” when considering wages, and that there is no reduction or “haircut” for contract research expenses. This means that a separate calculation will need to be completed – one that adjusts any wage QRE to specific percentages, and that adds back any reduction in contract research expenses. This separate calculation will provide the taxpayer with the number they need for the capitalization and amortization now required in the new section 174.
The official bulletin containing Rev. Proc. 2023-8 is not set for release until after the new year; however, an advance copy of the revenue procedure has been made available.
Rev. Proc. 2023-8 provides long-anticipated procedural guidance, the IRS has yet to release substantive guidance under new section 174, which likely will be required to properly apply the new rules. Rev. Proc. 2023-8 contains only the procedural component. Substantive guidance on applying the Section 174 amendment (definitions, explanations, examples, etc.) remains outstanding. It is anticipated the release of that substantive component sometime next year.
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