Research and Experimental expenditure required capitalization

Prior to 2022, not much thought was given to the treatment of research and experimental (R&E) expenditures under IRC 174 and the companies usually will deduct these costs as incurred. There was an option to capitalize these costs and amortize over 5-year period but none of the clients I had worked for capitalized R&E expenditures under this provision. Along with expensing these costs, several of my clients took advantage of R&D credit under IRC Sec. 41.

Under Tax Cuts and Jobs Act (TCJA) of 2017, starting for tax year 2022, taxpayers are required to capitalize these expenditures and amortize them over the 5-year period for expenditures attributed to domestic research or 15-year for expenditures attributed to foreign research. In addition, software development cost is now treated as R&E expenditure and is required to be capitalized and amortized similar to other R&E expenditures.

So, you ask what R&E expenditure is? IRC Sec 174 does not provide precise definition of what exactly qualifies as R&E but looking at the existing Treasury Regulations, 1.174-2(a), “section 174 expenditures are costs incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense. The term generally includes all such costs incident to the development or improvement of a product.… Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product…. The ultimate success, failure, sale, or use of the product is not relevant to a determination of eligibility under section 174”.

This is a very broad definition and will encompasses a lot of expenditures which generally we don’t think of as research. For example, for packers/processors, expenditures incurred to modify packing/sorting line, packing design change, and or testing new lines appears to fall within the definition. For nurseries, experimentation with fertilizers/soil amendments and any activity that is more than growing existing varieties will need to be analyzed to see if they fall within the definition.

Taxpayers who claim R&D credit cannot just capitalize qualified research expenditures (QRE) used for credit calculation. QRE are subset of the expenditure under Sec. 174 and amount that needs to be capitalized will be substantially more than QRE.

Good thing is (only tax accountant will say this), to adopt this new method of accounting, IRS issued proc 2023-8 allowing taxpayers to file a paper statement with their return in lieu of filing form 3115 if the method is adopted in the first tax year beginning after December 31, 2021. More on this can be read on CLA’s technology blog.

Taxpayers and practitioners had hoped that this provision of Sec. 174 will be reversed/postponed by the congress but hopes of that happening now are slim. Taxpayers should start evaluating if they have any expenditure that qualify as R&E and needs to be capitalized under this section.