Tax Cuts and Jobs Act Impact on IRC Section 174
The Tax Cuts and Jobs Act (TCJA) of 2017 presented one of the most sweeping and comprehensive tax-law changes U.S. taxpayers have seen in decades. As companies and tax professionals have analyzed and implemented a majority of the changes coming from TCJA, the amendments made to Internal Revenue Code (IRC) Section 174, which take effect for tax years beginning after December 31, 2021, pose yet one more significant TCJA change taxpayers must now consider. Specifically, companies incurring any expenses related to product, process, and/or software development will need to analyze their current tax treatment of these costs and consider how the amendment will impact their treatment going forward.
New Section 174 Tax Accounting Starting in 2022
Starting in 2022, TCJA amendments to IRC Section 174 will no longer permit an immediate deduction for research and development (R&D) expenditures, including those related to internally developed software, in the tax year that such costs are incurred. Instead, these IRC Section 174 development costs must now be capitalized and amortized over either a five- or 15-year period, depending on the location of the activities performed. The new amortization period begins with the midpoint of any taxable year that IRC Section 174 costs are first incurred, regardless of whether the expenditures were made prior to or after July 1, and runs until the midpoint of year five for activities conducted in the United States or year 15 in the case of development conducted on foreign soil. In the event that property for which Section 174 costs were incurred is disposed of, retired, or abandoned during its applicable five- or 15-year period, the taxpayer must continue the amortization for the full term to achieve full cost recovery.
Refresher on Eligible Costs and Relation to R&D Credits under IRC Section 41
Although the TCJA changed the general tax-accounting methods and rules related to recovering IRC Section 174 costs, the expenditures qualifying under IRC Section 174 remain unchanged. IRC Section 174 Regulations explain that qualifying R&D expenditures include all costs incident to the development or improvement of a product, including any costs in eliminating any uncertainties in the development or improvement of that product. A non-exclusive list of common qualifying costs includes labor (including employee benefits), experimental research, laboratory costs, rent and utilities for research facilities, and costs of obtaining a patent (including the related attorneys’ fees). Additional qualifying IRC Section 174 costs include amounts paid to others for the development or improvement of a product at 100% and software developed for a taxpayer’s internal use.
It should be noted that while Section 174 cost eligibility is a prerequisite for the identification of qualified research expenditures (QREs) used in calculating Section 41 research and development credits, the obligation created by the TCJA to capitalize and amortize development costs exists regardless of whether a taxpayer actually claims or can even utilize Section 41 credits.
Taxpayers May Be Required to File for an Accounting Method Change
For taxpayers that have historically elected to immediately deduct development expenses under the prior rules, mandatory amortization will undoubtedly give rise to a new tax-accounting treatment, which will almost undoubtedly require the inclusion of Form 3115 – Application for Change in Accounting Method on the first filed tax return, including such costs going forward, although no specific regulatory guidance has been issued as of yet.
In advance of 2022 year end, companies should endeavor to develop new procedures that will permit the efficient and accurate capture of costs affected by this change and ensure complete compliance. As such, Ryan’s tax-accounting experts can assist taxpayers in developing these cost identification and qualification efforts as well as facilitating any accounting method change, including communicating book-tax impacts.
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