Procedural guidance to comply with new rules for research and experimentation expenditures
Updated guidance as of December 29, 2022.
New Section 174 treatment of R&E expenditures
For the first tax year that begins after December 31, 2021, Section 174 no longer permits a direct expense, or immediate tax deduction, for R&E expenditures. Taxpayers are now required to capitalize and amortize R&E expenditures over a five-year period (15-year period for foreign research), beginning with the midpoint of the taxable year in which such expenditures are incurred.
In addition, there is no longer any distinction for costs incurred for software development that may or may not qualify as R&E expenses, because the new rules within Section 174 clearly state that any amounts paid for software development are to be treated as R&E expenditures and will be required to be capitalized and amortized over the five-year period (or 15-year for foreign research expenses).
Taxpayers should evaluate the impact of this change in the treatment of R&E, identifying all costs that should now be capitalized. Any taxpayer that has claimed the Research Credit and/or incurs costs for the development of software (even if it does not rise to the level of qualifying for the credit) will be required to comply with this change. These expenditures may include employee wages, third-party contract services performed on behalf of the taxpayer, and tangible supplies consumed during the research process. Taxpayers will have a significant reduction in their annual R&E tax deduction, which will result in an increase to taxable income.
Procedure to change the treatment of R&E expenditures
For the first taxable year that begins after December 31, 2021, taxpayers may file a statement with the filing of the tax return in lieu of the filing of a Form 3115. This statement is considered a Form 3115 for purposes of the automatic consent procedures, and the requirement for filing a duplicate copy that is generally required when filing a Form 3115 is waived. The change is effective on a cut-off basis, meaning that there is no change to taxable income for any costs incurred prior to the year of change.
These procedures significantly streamline the process for taxpayers to comply with the change and reduce additional administrative work that would ordinarily have been required with a change of accounting method.
If taxpayers do not comply with the change in the first taxable year that begins after December 31, 2021, then the filing of the Form 3115 is the required process for changing to the permissible method of accounting for R&E expenditures.
In addition to this administrative process, taxpayers will be required to calculate an adjustment to taxable income for any R&E expenditures incurred for tax years beginning after December 31, 2021.
Prior to the end of 2022, the IRS released additional new guidance modifying when taxpayers receive audit protection.
The original procedural guidance noted that taxpayers will not receive audit protection with the filing of this change for any expenditures incurred in taxable years beginning on, or before, December 31, 2021. However, further clarifying guidance subsequently stated that audit protection would not be granted for the expenditures incurred in taxable years beginning on, or before, December 31, 2021 and also would not be granted for expenditures incurred in taxable years beginning after December 31, 2021 if the change in method is not made in the first year of the change in law. For example, if a calendar year taxpayer makes the change for the 2022 tax year, no audit protection would be granted when filing the statement. However, if that same calendar year taxpayer did not file the Form 3115 until the 2023 tax year, no audit protection would be granted for all R&E expenditures. The clarifying guidance further encourages taxpayers to comply in the first taxable year that begins after December 31, 2021.
Taxpayers must be prepared to account for the tax treatment of R&E and software development costs differently and include this change with the filing of the tax year for the first year beginning after December 31, 2021. This will likely have an impact on other tax calculations that are based on taxable income and taxpayers should be prepared.
Please contact your Mazars professional for additional information.