The Impact of IRC Section 174 on Research and Experimental Expenditures

December 19, 2022 | Alert

By Erin Scow and Nicole Halverson, CPA

Changes to Section 174 will significantly impact the tax treatment of research and experimental expenditures.  

What is Section 174?

Prior to 2022, Section 174 allowed taxpayers to deduct research and experimental (R&E) expenditures. 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 the expenditures were properly classified as R&E expenditures under Section 174.

What changes are being made to Section 174?

Due to a provision of the Tax Cuts and Jobs Act (TCJA), which takes effect for tax years beginning after December 31, 2021, taxpayers must change how they treat R&E expenditures under Section 174.

Instead of currently deducting these expenses, taxpayers must charge them to a capital account and amortize the costs over a period of five years for research conducted in the United States or 15 years for foreign research. This means that taxpayers must determine the proper amount of their Section 174 costs as the treatment now differs from the treatment of otherwise deductible trade or business expenses under Section 162.

Since the ability to currently deduct R&E expenses is seen as an incentive to keep jobs in the U.S., there is broad support for legislation that would either repeal or delay the aforementioned changes to Section 174. However, it is currently unknown whether there will be a law change and whether the change would be retroactively effective to January 1, 2022. In addition, technical guidance on the capitalization of Section 174 costs is not expected until next year.

What is the IRS guidance related to these changes?

The IRS provided procedural guidance regarding the change in method of accounting for Section 174 expenditures required in the event the law is not delayed or repealed. The guidance allows you to file a statement with the necessary information in lieu of a Form 3115 (Application for Change in Accounting Method) to implement the required accounting method change for the first taxable year in which Section 174 capitalization becomes effective.

If a method change to comply with Section 174 is made for a taxable year subsequent to 2022, the change must be made by filing a Form 3115, with a modified Section 481(a) adjustment that considers only specified research or experimental expenditures paid or incurred in taxable years beginning after December 31, 2021.

What are the next steps for Section 174?

Although the law may still be repealed or delayed, it is important to evaluate how the transition to capitalizing Section 174 expenses will impact your 2022 income tax liability.

Determining this impact may depend, in part, on a taxpayer’s method of accounting.  However, the change may significantly increase taxable income if the law is not modified.

Therefore, taxpayers will need to develop a plan to identify and track Section 174 expenses to ensure accurate tax filings.

Unsure how to move forward with potential changes to Section 174?

This article is provided for general informational purposes only. It is not legal, accounting or other professional advice, as it does not address any individual facts, circumstances or concerns. Before making personal or business related decisions, please consult with appropriate legal, accounting or other qualified professionals.

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