Internal Revenue Code Section 174 Frequently Asked Questions
The following is a list of frequently asked questions and their answers related to Internal Revenue Code Section 174 (“IRC 174”)
What is IRC 174?
Answer: IRC Section 174 provides guidance for how businesses can treat research and experimental expenditures. It was enacted in 1954 and originally allowed for an election to amortize expenditures with the default treatment being expensing of research expenditures. The Tax Cuts and Jobs Act of 2017 (“TCJA”) modified 174 to disallow immediate expensing of expenditures starting in tax years that begin in 2022.
What changed with IRC 174 and why?
Answer: Section 13206 of the TCJA eliminated the ability for corporations to immediately expense qualified expenditures. With that option now removed from the statute, businesses must amortize these expenditures over 5 years (domestic) or 15 years (foreign). The change to IRC 174 was made along with various other changes to mitigate the tax revenue loss from other sections of the TCJA.
Is IRC 174 amortization mandatory?
Answer: Yes. Due to the change implemented in the TCJA, taxpayers lost the ability to expense research costs for tax years beginning in 2022. The change to IRC 174 was designed to raise tax revenues from businesses. Moreover, IRC Sections 6662 and 6694 specify penalties for taxpayers (20% of the underpayment) and tax return preparers (up to 75% of the fees) for underpaying taxes due to negligence or intentional disregard for rules or regulations.
Specifically, IRC 6662(b)(1) specifies that a penalty of 20% of the understated tax liability will be assessed if the understatement was attributable to “negligence or disregard of rules or regulations.”
IRC 6694(b) states that a preparer who prepares any return or claim for refund in which the understatement of liability is to willful or reckless conduct will pay the greater of $5,000 or 75% of the income derived for preparation of the claim. Reckless conduct is defined as “intentional disregard of rules or regulations.”
A corporation who, in tax year 2022, has $100,000 in research expenditures and does not amortize those costs would be understating income by at least $90,000. At a 21% tax rate, the tax liability would be understated by $18,900. In the event of an exam, the taxpayer would owe the $18,900 in taxes AND a penalty of $3,780.
The return preparer for this same corporation would be required to pay a penalty equal to the greater of 75% of the fees paid by the corporation for preparing the return or $5,000.
What costs must be amortized according to 174?
Answer: Treasury Regulations Section 1.174-2 provides various examples of research or experimental expenditures. Some of these are as follows:
Expenditures incurred in connection with a taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense. (Treas. Reg. Sec. 1.174-2(a)(1))
All such costs incident to the development of a product, process, formula, invention, technique, pilot model, or patent. (Treas. Reg. Sec. 1.174-2(a)(1))
Attorneys’ fees expended in making and perfecting a patent application. (Treas. Reg. Sec. 1.174-2(a)(1))
Expenditures incurred for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. (Treas. Reg. Sec. 1.174-2(a)(1))
Costs paid or incurred to another person or organization for research or experimentation on the taxpayer’s behalf. (Treas. Reg. Sec. 1.174-2(a)(10))
Costs for depreciable property used in research. (Treas. Reg. Sec. 1.174-2(b)(1))
Any cost associated with software development. (IRC Sec. 174(c)(3))
The term “uncertainty” means uncertainty regarding capability, methodology, or final design of the product. The term product also means internal use items as well as those intended for sale, lease, or license. (Treas. Reg. Sec. 1.174-2(a)(3)) In addition, taxpayers are required to shrink back to a component or subcomponent of a product in the event the overall product does not meet the criteria.
Exclusions to research and experimental expenditures (those not subject to IRC 174):
Quality control testing.
Efficiency surveys.
Management studies.
Consumer surveys.
Advertising or promotions.
The acquisition of another’s patent, model, production, or process.
Research in connection with literary, historical, or similar projects.
Payments for land or improvements to land.
Expenditures related to the exploration of any ore, oil, gas, or mineral.
Do I have to evaluate costs on a project-by-project basis?
Answer: No. Treasury Regulations Section 1.174-1 states that IRC 174 expenditures can be those related to a general research program or a particular project.
What happens if I am already capitalizing research equipment?
Answer: IRC 174(c)(1) (formerly IRC 174(c)) states that IRC 174 does not apply to any expenditures for land or property used in connection with research provided it is subject to an allowance for depreciation (per IRC 167) or depletion (per IRC 611). However, each year’s depletion or depreciation deduction IS an expenditure for purposes of IRC 174. Thus, property that is subject to 167 or 611 cannot be switched to a different capitalization schedule if it is used for research.
For example, a taxpayer spends $100,000 on a spectrometer in 2021. The spectrometer is a 10-year property and is exclusively used in research. Because the spectrometer is an IRC 167 property, the first year of depreciation deduction is $10,000. In tax year 2022, the depreciation deduction is $10,000 but because the device is used in research, the $10,000 deduction must be amortized over a 5-year period.
Is the determination of 174 amortization based on the nature of the expenditure or the activities my business does?
Answer: The determination of whether an expenditure is subject to treatment under IRC 174 is based first on the activities undertaken. (i.e. Is the activity research or experimentation undertaken to overcome uncertainty for a product, process, etc.?)
If the activities meet the requirements of IRC 174, the taxpayer must evaluate all costs associated with the activity or project to determine which must be amortized and to what extent.
How do I evaluate my records to determine what is subject to 174?
Answer: Given the broadly defined activities and types of costs that are subject to 174 amortization, it is wise to start with a very wide funnel and evaluate according to the statute and IRS guidance. It is not correct to ignore cost centers “whole cloth” which may have some involvement in qualified research activities.
What if I begin amortizing research property and I sell it before the amortization period ends?
Answer: TCJA modified IRC 174 to state that amortization will continue regardless of disposition, retirement, or abandonment. In short, once you amortize the expenditure, there is not an action you can take to accelerate the deferred deduction.
For example, if a company designs and builds custom, one-of-a-kind machines to sell to customers, the cost of the materials that go into each machine must now be amortized. The amortization will continue even after the machine is sold to the customer.
Do I have to file for a change in accounting method to comply with 174?
Answer: No. TCJA provided taxpayers and return preparers a means to adopt the new amortization method without having to file a change in accounting method. The changes are treated as an accounting method change according to IRC section 481, initiated by the taxpayer and made with the consent of the Secretary. Moreover, the change is applied on a cut-off basis meaning no adjustments are made pursuant to IRC 481(a) and the amortization method is not applied to 174 research costs incurred prior to the start of the taxpayer’s 2022 tax year. Moreover, the IRS released Revenue Procedure 2023-11 to clarify the TCJA changes and provides that the amortization period must begin at the midpoint of the taxable year in which the expenditures are paid or incurred. To comply with Rev Proc 2023-11, a taxpayer must include a statement in lieu of a Form 3115 in its 2022 tax year return. This statement must include the following:
The name and EIN/Social Security Number of the taxpayer.
The beginning and end dates of the applicable tax year.
Designated automatic accounting method change number: 265
A description of the type of expenditures being amortized.
The amount expenditures being amortized.
A declaration that the taxpayer is changing the method of accounting on a 5- or 15-year period (as applicable) beginning at the mid-point of the taxable year on a cut-off basis.
If I never claimed a R&D credit (IRC 41) but I have IRC 174 activities, do I need to worry about IRC 174 amortization?
Answer: Yes. Note that IRC 41 requires qualified research expenditures to first meet an IRC 174 requirement and then implements additional qualifiers. However, the converse is not also true. There are many industries and businesses that do not qualify for the IRC 41 credit but are still conducting activities subject to IRC 174. In addition, the IRC 41 credit is not compulsory – a taxpayer can qualify for it and not claim it without penalty. IRC 174 is now compulsory – any business with IRC 174 activities and expenditures is required to comply with the amortization requirement.
Can I just give my CPA my R&D credit QREs and have them amortize those?
Answer: No. The types of expenditures that qualify for the R&D credit will typically be a subset of the total IRC 174 costs.
If I have IRC 174 costs, does that mean I should be claiming an IRC 41 R&D credit?
Answer: Maybe. Having 174 expenditures does not mean a taxpayer also has IRC 41 credit qualifying expenditures. An analysis of activities and expenditures must be undertaken to evaluate what is and is not eligible for both IRC 174 and IRC 41.
What does this mean for my 2022 tax liability?
Answer: In short, all businesses subject to IRC 174 are having to defer their deductions over a 5- or 15-year period. This means income and, therefore, tax will increase relative to prior years. Unless a change is made beforehand, after a 5- or 15-year period, the income and tax levels should return to relatively close what they were in tax year 2021 (all other things being equal).
This timeline is more complicated by the midpoint rule, which effectively means that only half of the first-year amortization deduction can be claimed in tax year 2022.
Was I supposed to be identifying 174 expenditures before 2022?
Answer: Unless you were doing so as part of a Section 41 R&D credit study, no. Prior to the change in the TCJA, a business deducted most business expenditures pursuant to IRC Section 162. A business could identify IRC 174 expenditures and make an election to amortize them but the tax treatment was the same as if no election was made under 174. Thus, no additional steps were necessary until tax year 2022.
Does the change to IRC 174 affect state income?
Answer: Each state may adopt its own rules in response to the change to IRC 174. Many states have confirming provisions in their regulations to automatically adopt this type of change and taxpayers will see a similar increase in state tax liability. Other states do not have these conforming provisions. For example, California, Wisconsin, and Tennessee do not conform to the 174 change or enacted legislation to adopt the pre-TCJA IRC 174.