New Rules for Section 174 Research and Experimentation Expenditures

In a boon for businesses conducting research and development, the IRS recently finalized taxpayer-favorable regulations on the deductibility of research and experimentation (R&E) expenses. The amendments to Section 174 of the Internal Revenue Code address the misconception that no material or labor costs incurred to develop a tangible property can qualify as R&E expenditures.

Section 174 generally allows taxpayers to deduct R&E expenditures as they are paid or incurred or to treat them as deferred expenses that can be amortized of a period of no less than 60 months. The treatment of expenses for the development of tangible property has, however, always been nebulous and subject to various interpretations. Qualifying expenses as R&E expenditures is particularly important because it is the very first test that has to be met for an expense to be included in the calculation of the Section 41 Credit for Increasing Research Activities – commonly known as the federal research credit or R&D tax credit.

The IRS recently amended Section 174 to clarify that:

• The term “pilot model” means any representation or model – including a fully-functional one – of a product that a company produces to solve an uncertainty regarding the development or improvement of that product.
• The only costs eligible under Section 174 are those incurred or paid while the business is attempting to solve an uncertainty related to the development or improvement of a product.
• The subsequent success, failure, sale, or other use of the tangible property developed is irrelevant when determining whether expenses qualify as Section 174 expenditures.

The final regulations apply to tax years ending on or after July 21, 2014, as well as tax years that have not closed, according to the limitations period.

When is an uncertainty not uncertain anymore?

Based on the clarifications above, the notion of uncertainty is the key to qualifying expenses for the development of tangible property under Section 174.

While a business is attempting to solve an uncertainty related to either its capability or method of developing a product or regarding the most appropriate design of that product, the costs it incurs could qualify under Section 174.  It doesn’t matter whether or not the product is ultimately is sold or used in the business. However, the costs incurred in the construction or production of the product after uncertainties have been eliminated will not qualify. This is where things get challenging.

On paper, the distinction between the development and post-development phases may make sense. In reality, the process of developing or improving tangible property is not perfectly linear and unidirectional. Therefore, there is no bright-light test to determine when an uncertainty is not uncertain anymore and which expenses relate to development and post-development phases, respectively.

The taxpayer’s facts and circumstances need to be considered. Documenting the existence of uncertainties at the different development stages will be absolutely critical for substantiating R&E expenditures in order to claim the R&D tax credit.

Deducting expenses of experimental trials

Finally, while the recent amendment focuses on tangible property, the clarification regarding the subsequent sale or usage is also extremely relevant for taxpayers conducting experimental trial runs. In certain industries, it’s often necessary to run full-scale experimental trials in order to eliminate technical uncertainties.

Take the cement industry for example. It’s impossible to accurately reproduce in a lab the thermal and chemical reactions needed to make cement, and experimental trials are often conducted between production runs. Sometimes, the output of these trials meets the quality specifications and can be sold. Based on the clarification to Section 174 regarding subsequent events, despite the sale of the end product, if the trial was performed to eliminate uncertainties, the raw materials and the labor required could qualify as R&E expenditures. If the other requirements of Section 41 are met, the expense might also be eligible for the R&D tax credit.