As we move into the 2022 tax filing season, taxpayers face the mandatory method change for treating Internal Revenue Code (IRC) Section 174 research and experimentation (R&E) expenditures. Historically, since 1954 taxpayers could either deduct in the current tax year or capitalize and amortize R&E expenditures and software development costs, generally over a period of sixty months. However, under the Tax Cuts and Job Act of 2017, all taxpayers must capitalize and amortize R&E expenditures and software development costs for tax years beginning after December 31, 2021, using a half-year convention of the tax year these costs were paid or incurred.
What is IRC Section 174?
IRC Section 174 can be defined as “expenditures in connection with the taxpayer’s trade or business, representing research and development costs in the experimental or laboratory sense.” Additionally, R&E expenditures include “all costs incidental to the development or improvement of a product.”
What Do These Changes Mean?
The amended IRC Section 174 treatment requires taxpayers to capitalize R&E expenditures and software development costs and amortize these expenditures over a five-year period for domestic expenditures and a 15-year period for foreign research for tax years beginning after December 31, 2021, using a half-year convention. This change method can potentially increase taxable income by deferring deductions in future years. This affects every taxpayer regardless of whether they take advantage of the IRC Section 41 research credit. Taxpayers will have to distinguish R&E expenditures and software development costs from other immediately deductible expenses. This was not an issue in earlier tax years since similar expenses could be deducted in the current tax year. Taxpayers must also consider how the IRC Section 174 method change will affect items such as estimated tax payments, cash flow, state and local tax, tax provisions, research credits, NOL carryforwards, and more.
Our Insights
With the unfavorable nature of the changes made to the treatment of IRC Section 174 costs, we predict the Section 41 research credit, cost segregation studies, and Section 179D energy efficiency deductions will be more valuable than ever, as they will help offset the potential additional tax liability. Additionally, the IRS published Revenue Procedures 2023-8 and 2023-11, which address procedural guidance, an automatic method change, and audit protection for R&E expenditures and software development costs.
How Calvetti Ferguson Can Help Offset Your Tax Liability
Taking advantage of current and ever-changing tax laws and avoiding painful tax mistakes requires technical skills, knowledge, and forward thinking. Our tax incentives professionals will assist you in identifying, capturing, and reporting additional tax credits and deductions to help offset your other tax liability generated from the IRC Section 174 method change.
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