Research & Experimentation expenses must now be amortized

Section 174 changes are fully applicable to the 2022 tax year

Companies no longer have the option to immediately deduct research and experimentation (R&E) expenses that fall under Section 174 of the Internal Revenue code. Instead, they must capitalize and amortize them, either over five years for expenses incurred in the U.S., or over 15 years for expenses incurred outside the country. Costs must continue to be amortized even if the property or project is disposed of, retired or abandoned.

Why the change? Congress was in search of revenues and decided to change Section 174. New Section 174 went into effect in 2022 under the Tax Cuts and Jobs Act; many had hoped Congress would reverse those changes as the year came to a close, but it didn’t happen.

For companies with these types of expenses, this rule change effectively increases current-year taxable income and defers deductions into the future. R&E expenses covered by Section 174 (and therefore subject to this new amortization rule) include both direct and indirect costs of research and experimentation. These can include wages for those working on the research and those supervising that work, as well as supplies, outside research providers, rent, utilities, overhead, patent-related expenses, and third-party-funded research.

Additional changes to Section 174 broadened the scope of expenses that fall under Section 174 to now include all software development costs. It now says that “any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.” These costs must be amortized. Software that is acquired – through purchase, lease, license or other means – is not covered by Section 174 and is accounted for under Rev. Proc. 2000-50 which mandates amortization over 36 months, treated as rent or depreciated along with related hardware.

Changing your method of deducting R&E expenses

Historically, Section 174 allowed companies that incurred expenditures while conducting R&E the choice between immediately deducting R&E expenditures or capitalizing and amortizing them over periods of time.

For companies that have been immediately deducting R&E expenditures, the required amortization is an accounting method change. Although such changes typically require a Form 3115, which can be complex to prepare, the IRS has provided a simpler way to make this change.

IRS Revenue Procedure 2023-08 allows companies to adopt the new required capitalization of R&E expenses by attaching a statement to their 2022 tax returns. Tax returns for 2022 that are filed before Jan. 10, 2023, do not have to include a statement; the IRS considers those companies in compliance as long as they properly report R&E expenses on Form 4562, Part IV.

Possible ramifications of the new requirement to amortize R&E expenses

Talk with your tax professional to identify which research expenses need to be amortized, as well as whether you need to increase your estimated tax payments to account for higher income this year. You may also explore whether to use more of a net loss carryforward or tax credit in the 2022 tax year in order to reduce your tax liability.

To offset some of the higher tax burden you may be facing due to these new amortization rules, you may want to explore whether your company can take advantage of the federal research tax credit (formally the Credit for Increasing Research Activities). A research tax credit expert can help you explore whether you have expenses that qualify for this dollar-for-dollar offset of tax paid or owed.

Reach out to a Kaufman Rossin tax professional to learn more about how the new R&E expenses amortization rules might affect your tax bill, as well as to learn more about whether you might benefit from the R&D tax credit. Kaufman Rossin’s tax credits and incentives team has years of experience in this specialized area. With backgrounds in engineering and tax expertise, they can guide you through the full process.