The Impact of Changes to Section 174

Section 174 is particularly impactful for companies engaged in research and development activities. Section 174 requires Specified Research and Experimental (SRE) expenditures in tax years beginning after December 31, 2021, to be capitalized and amortized rather than currently deducted.

Specified Research and Experimental activities are defined as software development activities or research or experimental activities.

Taxpayers must determine the proper amount of Section 174 costs as the treatment now differs from the treatment of otherwise deductible trade or business expenses under Section 162.

What’s Included in Section 174

Section 174 covers a wide variety of SRE-related activities and costs that should and should not be capitalized.

SRE Expenditures

SRE expenditures include all costs outlined in Section 41 and additional costs resulting from specified research and experimental activities.

Examples of SRE expenditures include:

• Labor costs (including elements of compensation other than severance compensation, such as overtime pay, vacation pay, and payroll taxes)
• Materials and supplies costs
• Cost recovery allowances (depreciation, amortization, and depletion allowances)
• Patent costs
• Certain operation and management costs (e.g., rent, utilities, insurance, taxes, etc.)
• Travel costs for SRE activities or direct support activities

Examples of non-SRE expenditures include:

• Costs from general and administrative service departments that only indirectly support SRE activities
• Interest on debt to finance SRE activities
• Costs to input content into a website
• Amounts representing amortization of SRE expenditures
• Costs to register an internet domain name or trademark

Foreign Research

To account for SREs attributable to foreign research, costs should be amortized over the appropriate timeframe, dependent on where the research activities are performed. For foreign research activities where a cost-sharing arrangement is in place with a related U.S. entity, an analysis of the cost-sharing arrangement is necessary to allocate the costs appropriately.

Changes to Section 174 Guidance

Prior to 2022, Section 174 allowed taxpayers to deduct R&E expenditures fully. These include direct research expenses, like wages and supplies, and indirect research expenses, like overhead and administrative costs related to research activities.

Taxpayers previously deducted these expenses in the year they were incurred. Because the treatment of R&E expenditures under Section 174 did not differ from the treatment of ordinary business expenses deductible under Section 162, most taxpayers did not perform an analysis to determine whether business expenditures were properly classified as R&E expenditures.

Section 174 requires SRE expenditures in tax years beginning after December 31, 2021, to be capitalized and amortized rather than currently deducted. The amortization period is five years for domestic and 15 years for foreign research costs.

Taxpayers are required to request a change in the method of accounting to apply the amended Section 174 rules if Section 174 guidance was not followed for the first return filed for a tax year after 12/31/2021.

Research Performed Under a Contract

Research providers must capitalize SRE expenditures if the research provider bears financial risk under the contract or has the right to use any SRE product in a trade or business. However, a research provider must receive more rights than simply an “excluded SRE product right” for its paid or incurred costs to be considered SRE expenditures.

Excluded SRE product rights are defined as rights separately bargained for the limited purpose of performing SRE activities under the related contract.

Software Development

Software development activities are subject to capitalization under Section 174 and include upgrades and enhancements to software. Capitalization of costs is required through the lifecycle of the development (from planning through writing and testing of the software).

All software development costs incurred in tax years beginning after December 31, 2021, must be capitalized and amortized under Section 174 and are no longer allowed as a current deduction.

Updated Accounting Method Change Procedures for Section 174

Taxpayers must modify their Section 174 methods for the second tax year beginning after December 31, 2021.

The guidance applies to taxpayers who wish to change their method of accounting for SRE expenditures paid or incurred in taxable years beginning after December 31, 2021, to:

• Comply with amended Section 174.
• Rely on optional interim guidance provided in Notice 2023-63.

Long-Term Contract Rules

Income on long-term contracts is generally reported on the Percentage of Completion Method (PCM), determined based on the percentage of total costs incurred before the end of the current tax year (numerator) over total contract costs (denominator).

Now taxpayers are only required to include the allowable amortization of SRE expenditures in the numerator of the PCM calculation (rather than the entire amount of costs incurred).

Taxpayers have two options to compute their estimated total contract costs (denominator):

• Include all amortization of SRE expenditures that directly benefit or are incurred because of the performance of the long-term contract.
• Include only that portion of such amortization expected to be incurred and deducted during the contract term.

What This Change Means for Taxpayers

A common misconception is that Section 174 capitalization is only required if taxpayers take the R&D Tax Credit. All SRE expenses must be capitalized and amortized regardless of whether the taxpayer claims the R&D Tax Credit. And this applies to taxpayers with any amount of R&E expenses (there is no de minimis exception).

The impact of capitalizing Section 174 expenses differs based upon the unique facts of a taxpayer’s business. Taxpayers must develop a plan to identify and track Section 174 expenses to ensure accurate tax filings.