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Amortization of Specified Research or Expenditures under Section 174
The IRS released Notice 2023-63 offering additional guidance on the treatment of Section 174 specified research or experimental expenditures. This guidance is applicable to tax years ending after September 8, 2023. Taxpayers are not required to immediately follow the guidance provided by the notice but can choose to if all rules of the interim guidance are met. The IRS will provide additional procedures for taxpayers to change their method of accounting to comply with this notice and intend for this change to be eligible under the automatic consent procedures.
The Tax Cuts and Jobs Act (TCJA) eliminated the option to expense Specific Research or Experimental (SRE) expenditures. SRE expenditures under IRC Section 174 are now required to be capitalized and amortized over a period of five or fifteen years. The guidance provided by this notice touches on proper treatment for complying with these newly implemented rules by the IRS. Additionally, Notice 2023-63 covers identification and allocation of SRE expenditures, software development, research performed under contracts, short tax years, and disposition or retirement of property.
SRE expenditures are newly defined as research or experimental expenditures that are paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business. These expenditures do need to qualify as research or experimental expenditures under Treasury Regulation Section 1.174-2. In addition, software development costs are required to be treated as SRE expenditures. Software development is defined by any amount paid or incurred in connection with the development of any software in taxable years after December 31, 2021. Software development activities are research or experimental activities in the experimental or laboratory sense intended to discover information that would eliminate uncertainty concerning the development, improvement or appropriate design of a product, a component or subcomponent of a product. Treasury Regulation Section 1.174-2 touches on more details of qualifications for software development. SRE expenditures include all costs related to what is defined above including software development and all costs directly supporting the SRE expenditures and activities. Examples of these direct expenses include labor costs, materials and supplies costs, cost recovery allowances, patent costs, certain operation and management costs, as well as travel costs. Some costs that are incidental to SRE activities or paid in connection with software development activities cannot be treated as SRE expenditures. Some examples of these costs that are excluded include costs paid by general and administrative service department that indirectly support or benefit SRE activities, interest on debt to finance SRE activities, costs to input content into a website, as well as amounts representing amortization of research or experimental expenditures paid or incurred in taxable years beginning before January 1, 2022.
In determining whether a cost is considered software development for Section 174 purposes, the guidance provides a list of activities that are treated as software development. The list includes but is not limited to: planning and development of computer software, designing computer software or upgrades to software, building a model of the computer software, writing a source code and converting it to machine-readable code, specified testing of the computer software, as well as production of the product master for software developed for sale or licensing to others. The guidance also provides examples of those activities that are not treated as software development. This covers computer software developed by a taxpayer for use in its trade or business, and computer software developed for sale or licensing to others. Included in these two broad categories is any training for employees of the stakeholders that will use the software, maintenance activities after the software is placed in service that do not give rise to upgrades or enhancements, data conversion activities, as well as installing computer software and other activities relation to placing the computer software in service.
For taxpayers with research performed under contract, the notice provides information in determining if costs paid or incurred for research under contract are SRE expenditures under Section 174. The definition of a research provider and research recipient states that the performance of the services must be at the research recipient’s order and risk. For a research provider to incur SRE expenditure costs in performing research activities the research provider must bear financial risk or have a right to use any resulting SRE product in its trade or business, or otherwise exploit any resulting SRE product through sale, lease, or license.
Notice 2023-63 provides information for the application of these rules for short taxable years. The amortization deduction for a short taxable year is dependent on the number of months in the short taxable year. If part of a month is included in the taxable year, then the entire month will be considered in the number of months in the taxable year. The midpoint of a short taxable year is the first day of the midpoint month.
If property in which SRE expenditures are paid or incurred is disposed of, retired, or abandoned during the applicable amortization period, no recovery is allowed with respect to the unamortized SRE expenditures on account of such disposition, retirement, or abandonment. The taxpayer that disposed of, retired, or abandoned such property continues to amortize such expenditures under the applicable 174 amortization period. Section 7 of Notice 2023-64 touches on SRE expenditures in instances of sales of property and transactions in which a corporation ceases to exist.
It is anticipated that the impending proposed regulations will provide rules that are consistent with the rules described in this notice for taxable years ending after September 8, 2023. Until the issuance of the regulations, a taxpayer may choose to rely on the guidance provided by Notice 2023-63 provided that the taxpayer applies them in a consistent manner. Please contact your tax professional at Dermody, Burke & Brown so we can help you navigate the complexities of these new filing requirements.
The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.