IRS Issues §174 Capitalization Guidance
On December 12, the IRS issued Revenue Procedure 2023-8 setting forth guidance for taxpayers making accounting method changes under the new §174 capitalization rules that went into effect on January 1, 2022. The guidance comes at a time when taxpayers and practitioners are still hopeful that the capitalization requirement will be deferred or eliminated by Congress and full expensing will be restored.
Background on §174
Historically, §174 allowed taxpayers to currently deduct research and experimental (R&E) expenditures in the year incurred. Companies large and small that engage in research-based activities relied on full expensing as a significant cost recovery mechanism since §174’s enactment in the 1950s.
The Tax Cuts and Jobs Act (TCJA) of 2017 made a significant change to §174 that went into effect for taxable years beginning after December 31, 2021. The law change eliminated the ability to currently deduct R&E expenditures. Instead, taxpayers must now capitalize and amortize these costs. The amortization period is 5 years for domestic expenditures and 15 years for foreign expenditures. The TCJA also specifically added software development to the definition of R&E expenditures under §174.
Method change procedures under the new guidance
Revenue Procedure 2023-8 adds the §174 capitalization change to the IRS’s list of automatic accounting method changes taxpayers can make on Form 3115, Application for Change in Accounting Method. This particular method change is made on a “cutoff” basis, meaning that taxpayers implement the change with their first taxable year beginning after December 31, 2021 without any adjustment for expenditures incurred in previous years.
However, should a taxpayer fail to adopt the new method timely in year one, a method change in a subsequent year will require a modified §481(a) adjustment that takes into account R&E expenditures arising in taxable years beginning after December 31, 2021.
In lieu of a Form 3115, taxpayers are permitted to file a statement with their tax return for their first tax year beginning after December 31, 2021. The IRS will treat such a statement as a Form 3115 for purposes of the automatic method change procedures. If a change is made in a subsequent taxable year, then it must be made by filing a Form 3115, with the modified §481(a) adjustment.
What does this mean for taxpayers?
The new revenue procedure comes as Congress eyes a potential legislative deferral of the §174 capitalization change with retroactive effect back to January 1, 2022. This would essentially make the new guidance moot – at least for the time being. Taxpayers and practitioners have been hopeful that a fix would be addressed in a year-end tax extenders bill; however, that hope is fading quickly given the current lame duck Congress and the legislative need to fund the government. Alternatively, the new Congress could address the issue early in 2023, in which case taxpayers will need to continue accounting for the change for estimated tax and financial reporting purposes.
How we can help
Many taxpayers have never separately accounted for their §174 expenses, and this law change can seem like a daunting task. CLA’s R&D Tax team can assist your organization in identifying your §174 expenses and preparing necessary accounting method changes. This can also be done seamlessly as part of an R&D tax credit analysis. Contact your CLA professional to learn how we can help your organization comply with these new rules.
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