174 R&E amortization explained and what to do
By Brian Coddington, Source Advisors
February 2, 2023
Significant changes related to Section 174 research and experimental (R&E) expenditures went into effect at the beginning of 2022. Guidance released by the IRS under Rev. Proc. 2023-11, which updates Rev. Proc. 2023-08, provides procedural guidance on how to implement the change to amortizing Section 174 R&E costs over a five-year period (15 years for foreign research).
Background of Section 174 R&E amortization
Section 174 of the U.S. tax code applies to the treatment of R&E expenditures, which became part of the Internal Revenue Code in 1954. Historically, it allowed for the deduction or amortization of direct and indirect costs for R&E activities.
Recent changes to Section 174 amortization
Taxpayers that have R&E expenditures or software development costs must now amortize the costs over five years. The costs can no longer be deducted in the year period or incurred.
The change in treatment of R&E expenditures was part of the Tax Cuts and Jobs Act (TCJA),which now requires the amortization of R&E expenditures paid or incurred for any tax years that begin after Dec. 31, 2021. This means Section 174 now requires taxpayers to amortize R&E expenditures over a period of five years for domestic research costs or for a period of 15 years for foreign research costs. The TCJA also clarified that all software development costs are now deemed to be Section 174 expenditures and must be amortized.
Taxpayers are required to amortize costs falling under broader definitions of research, whether or not they claim the research and development (R&D) tax credit. Compliance with Section 174 is completely separate from Section 41, the R&D tax credit. However, claiming the R&D tax credit could potentially offset some of the tax resulting from the amortization of Section 174.
Software developers and Section 174
The new changes to Section 174 have a significant effect on software developers. Specifically, any cost that has been paid or incurred related to software development is now considered a Section 174 R&E expenditure. Therefore, it must be capitalized and amortized over five years (15 years for foreign software development).
What are Section 174 costs, research and experimental expenditures?
A Section 174 Expense can include:
- Direct costs, including Section 41 costs.
- Occupancy costs, including office rent and research facilities costs.
- Equipment rental costs.
- Heat, light, telephone bills and similar overhead utility costs.
- Depreciation.
- Travel expenditures that have been incurred for R&E purposes.
- Dues and publication expenses that have been incurred for R&E purposes.
- Attorney fees or filing fees related to patents.
As shown above, expenditures can include gross salaries, some general payroll costs, heating, lighting, power, office supplies, laboratory materials and software licensing. However, it should be noted that guidance on the potential expenditures of Section 174 is still vague.
Working with tax professionals who are familiar with Section 174 and up-to-date with the current laws can help taxpayers identify potential cost centers and departments where these expenditures could apply.
How does Section 174 work?
Section 174 works by no longer allowing taxpayers to fully deduct their R&E expenses in the current tax year, which ultimately will impact cash flow. For example, let’s say a taxpayer incurs research expenses totaling $1 million that fall under Section 174 in their 2022 tax year.
Due to the five-year amortization with the half year convention, the current year deduction would be $100,000. This would create a 90% reduction of the original $1 million deduction. This taxpayer would realize an increase in taxable income of $900 thousand.
Also as mentioned, foreign research costs require a 15-year amortization.
Filing your returns
Guidance is still being finalized in terms of the new changes to Section 174 and therefore, any taxpayers will need to be prepared to understand the Section 174 impact when making any tax payments along with any extension. Taxpayers who are considering delaying their tax filing, still need to know the extent of their potential tax change with Section 174 and will need time to properly compute any R&D tax credits to help offset the additional taxes.
What about Section 59(e)(2)?
The instructions for Forms 6251 and 4562 together provide that only R&E costs deducted in full in the year paid or incurred are subject to an AMT adjustment and only pre-2022 R&E costs can use the Section 59(e)(2) election.
Get help from the experts
One of the best ways to offset additional taxes as a result of these new mandatory changes to Section 174 is to take advantage of the R&D credits. If you have any Section 174 costs and are developing a product, improving processes or developing software, it is likely you also have R&D credits. Our team at Source Advisors can help you navigate these changes through webinar offerings and direct meetings with our R&D tax professionals.
Brian Coddington is the director of tax accounting methods and credits at Source Advisors. You may reach him at brian.coddington@sourceadvisors.com.
