- The IRS and the Treasury Department released guidance refining capitalization and amortization, as well as accounting method change procedures, for Section 174.
- Rev. Proc 2024-09 updates automatic accounting method change procedures and provides additional guidance for long-term contract rules and operations related to SRE expenditures.
- Notice 2024-12 refines guidance on capitalizing SRE expenditures, including criteria for capitalizing contract-based research and limitations on partnership property contributions.
The Department of the Treasury and the IRS have recently issued guidance related to capitalization and accounting method procedures for Section 174.
Notice 2024-12 provides updated guidance for Section 174 capitalization methodology. Rev. Proc. 2024-09 modifies the accounting method change procedures for Specified Research or Experimental expenditures under Section 174.
Updated Guidance for Section 174 Capitalization Methodology
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. The amortization period is five years for domestic research costs 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.
Notice 2024-12 clarifies and modifies guidance regarding capitalizing and amortizing SRE expenditures. Taxpayers are only required to apply the guidance outlined within final regulations.
- Research performed under a contract: Research providers are required to 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, Notice 2024-12 clarifies that 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.
- Partnerships: Section 7 of Notice 2023-63 cannot be relied on concerning property that is contributed to, or distributed/transferred from, a partnership.
- Rev Proc 2000-50: Rev. Proc. 2000-50 is superseded by Section 174 for tax years beginning after December 31, 2021. As a result, 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 under Rev. Proc. 2000-50.
Updated Accounting Method Change Procedures for Section 174
Rev. Proc. 2024-09 updates the automatic accounting method change procedures for taxpayers to 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 (as modified by Notice 2024-12).
Additional Guidance on Long-Term Contract Rules
Notice 2023-63 and Rev. Proc. 2024-09 also provide additional guidance regarding the interaction of the long-term contract rules under Section 460 and amended Section 174. Under Section 460, 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).
Under Notice 2023-63, taxpayers are only required to include the allowable amortization of its SRE expenditures in the numerator of its PCM calculation (rather than the entire amount of costs incurred).
Rev. Proc. 2024-09 provides two options for taxpayers 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 term of the contract.
How to File Under 2024-09
Accounting method changes under Rev. Proc. 2024-09 must be made by filing Form 3115. A modified Section 481(a) adjustment that considers SRE expenditures incurred in tax years beginning after December 31, 2021, is also required.
However, if the modified Section 481(a) adjustment results in a reduction in taxable income, the taxpayer can implement the change on a cut-off basis and only apply the method to expenditures incurred on or after the beginning of the year of change.
Audit protection under Rev. Proc. 2024-09 does not apply for expenditures paid or incurred in taxable years beginning before January 1, 2022. Audit protection will also not apply to expenditures paid or incurred in taxable years beginning after December 31, 2021, if the taxpayer did not make, or attempt to make, a change in method of accounting for the first tax year beginning after December 31, 2021.
Next Steps for Section 174 Guidance
Tax legislation is currently proposed that would allow taxpayers to immediately expense domestic SRE expenditures paid or incurred in 2022 through 2025 rather than requiring them to be amortized over multiple years, as under current law. The future of this legislation is uncertain.
Regardless of the legislative outlook, taxpayers with SRE expenditures should review prior year calculations to determine compliance with the requirements of Section 174 and consider the potential impact of applying the interim guidance in Notice 2023-63 and Notice 2024-12.