Section 174 Capitalization Uncertainty: Answers to Top FAQs

Our January 2023 article regarding the capitalization of research and experimental (R&E) costs under Internal Revenue Code Section 174 sketched a rather gloomy picture for U.S. companies.

Today the landscape unfortunately has not changed much. In fact, the situation became even more difficult to navigate as the technical issues and unanswered questions under Section 174 and the Tax Cuts and Jobs Act (TCJA) came into sharp focus when taxpayers prepared returns and estimates for the March 15 deadline.

We compiled seven FAQs to help you understand where this issue currently stands and how it might impact your organization.

Frequently asked questions

Will Section 174 capitalization be deferred or eliminated?

This is understandably the question on everyone’s mind, and probably the hardest one to answer. Despite there being bipartisan support in Congress to restore full R&E expensing, finding compromise on other tax issues as well as a legislative package to include a Section 174 fix is proving difficult.

The recent legislation advanced by the House Ways and Means Committee could be a step toward a restoration of full R&E expensing; however, there’s still a long way to go in Congress, and whether a retroactive fix for tax year 2022 would ultimately be included is a wild card. As such, organizations must continue to comply with the capitalization requirement for now.

Where is guidance needed under Section 174?

Taxpayers are struggling with several areas related to Section 174 because of a glaring lack of guidance. Keep in mind that most of the guidance currently in place under Section 174 was written several decades ago. What’s more, the guidance was written and interpreted as taxpayer-friendly with full expensing in mind. Thus, trying to apply these rules to the current environment of R&E capitalization is problematic.

A few areas where guidance is critically needed include:

• Scope of Section 174 — Perhaps the largest area of uncertainty caused by the law change is determining the scope of Section 174. Treasury regulations state Section 174 applies to all “costs incident to the development or improvement of a product.” For this purpose, a product includes “any pilot model, process, formula, invention, technique, patent, or similar property….” With this expansive definition, indirect costs such as utilities and depreciation relating to R&E activities get swept into Section 174; however, we do not know just how far it stretches. Again, where this broad definition was taxpayer friendly before the law change, it has quickly become punitive in the age of capitalization.
• Research funding — While the research tax credit has its own body of law regarding research funded by another party, Section 174 does not have a close analog. Determining which taxpayer in a contractual relationship should be capitalizing their R&E is a major point of uncertainty right now.
• Interplay with Section 460 — Taxpayers using the percentage of completion method (PCM) of accounting under Section 460 are trying to determine whether PCM might trump Section 174, which generally would be a favorable position resulting in the capitalization of only non-job R&E costs. Job-related R&E costs would be accounted for under PCM, where further capitalization may not be required. Such a position may present a high degree of risk, however, in the absence of clear guidance.
• Interplay with AMT — With alternative minimum tax (AMT), the general rule is unless a taxpayer materially participates in an activity, R&E costs under Section 174(a) are required to be amortized over a 10-year period. To avoid having an AMT adjustment, taxpayers are allowed to make an election under Section 59(e)(2)(B) for regular tax purposes to amortize their share of R&E costs over a 10-year period. But Congress did not amend the AMT rules (specifically the 10-year amortization election) with the Section 174 capitalization change. As a result, there’s uncertainty with what to do for AMT purposes and whether the so-called 59(e) election is still valid.
• Short years and dispositions — Section 174 is not clear regarding how taxpayers experiencing a short year and how unamortized R&E costs should be treated following a sales transaction. These issues are sure to cause disagreement among buyers and sellers and their transaction advisors.

When will guidance be issued?

It might be several months before guidance is released. A Treasury official said in February that guidance was not imminent. However, an official with IRS chief counsel recently stated the IRS was actively working on guidance but could not guarantee it would be released by the end of the year.

Although it is promising to hear that Section 174 guidance is in the works, it seems very possible taxpayers will be filing their 2022 tax returns with many questions unanswered.

How is software development impacted?

Section 174 now explicitly applies to software development costs, thus making the guidance set forth in Revenue Procedure 2000-50 largely obsolete. That revenue procedure was the key piece of guidance regarding the tax treatment of software development costs for many years and generally permitted full expensing.

New Section 174 expressly covers software development costs, but the statute does not define the term “software development.” Additionally, no distinction is made between software developed for internal or external use.

Traditional thought is that software development generally means activities resulting in new software features or enhancements, and activities relating to software installation, configuration, and bug fixes/maintenance are non-development activities. This distinction will likely guide taxpayers for the time being in the absence of guidance to the contrary.

How does R&E capitalization affect the research tax credit?

The short answer is the research tax credit under Section 41 is not directly impacted by the Section 174 change — the credit is still calculated in the same manner using the same costs. In many cases, the research credit will be even more important to help reduce the additional tax liability generated by the change in R&E treatment and addback to taxable income.

The research credit is based on a subset of expenses that fall under Section 174. In other words, Section 174 can be much broader in scope and applies to expenses not eligible for the research credit.

Even though the underlying research credit calculation did not change, there is a change affecting the expense disallowance mechanism set forth in Section 280C that might make the credit more generous for many companies beginning in 2022.

Section 280C disallowance change

Section 280C required taxpayers claiming the research credit to reduce their deductible credit-eligible expenses by the amount of the credit. However, Section 280C(c) permits taxpayers to make an election to claim a reduced research credit to avoid the deduction disallowance — the credit is reduced by the corporate tax rate, which is presently 21%. The election can only be made on an originally filed return, including extensions.

In concert with the Section 174 change, the TCJA also changed the deduction disallowance rule under Section 280C. Now, Section 280C requires a reduction in a taxpayer’s credit-eligible capitalized expenditures only when the amount of the credit exceeds the current year deduction for the expenditures. Such current year deduction will generally be 10% using a five-year amortization period and the required midpoint convention.

Due to the mechanics of the research credit’s base amount, it will be rare for taxpayers’ credits to exceed 10% of their deductible costs for the credit year. This means a reduction of capitalized amounts would not be necessary, and electing the reduced credit would not be advisable. Consequently, many taxpayers will be claiming a larger research credit on account of the statutory change.

How do states treat Section 174?

Not surprisingly, this depends on the state. Most states that impose an income tax follow the federal treatment of Section 174. There are some notable exceptions, however, with California being the largest since it generally does not conform to changes made by the TCJA.

Taxpayers with R&E in 2022 will need to work closely with their advisors to evaluate their state filing footprints and determine the proper treatment in each jurisdiction.

With all this uncertainty, should I extend my 2022 tax return?

Yes. Businesses and individuals impacted by Section 174 should consider extending their returns in hopes of full R&E expensing being restored by Congress retroactively for tax year 2022, or the issuance of much needed guidance by the IRS and Treasury should Congress fail to act. Also, an extension may prove beneficial by giving taxpayers the ability to file a superseding tax return.

Filing a superseding return

A superseding tax return is one filed after an extension but before the extended due date. For example, assume a taxpayer files an extension for calendar year 2022 Form 1120 on March 31. This will extend the due date from April 18 to October 16. Assume the taxpayer files their return on June 30 but subsequently identifies an error. The taxpayer can file another return to correct the error before October 16, i.e., a superseding return, that will be treated as an original return for most purposes.

A superseding return could be preferable to an amended return in the current Section 174 environment. This may be particularly true for partnerships subject to administrative adjustment request procedures, which can be complicated and onerous.

Additionally, two elections impacting the research tax credit on account of Section 174 cannot be made on an amended return but could be made on a superseding return. The first is the Section 280C(c) reduced credit election discussed above; the second is the payroll tax election under Section 41(h) available to qualified small businesses.

Generally, a taxpayer with a net operating loss that is also a qualified small business will elect to apply the research credit against payroll tax under Section 41(h) since there’s no income tax liability to offset. However, the Section 174 capitalization addback now in effect may push the same taxpayer into a taxable income position, creating a need to apply the credit against income tax on the return.

Should Congress pass a measure to retroactively restore full R&E expensing after the taxpayer’s original return has been filed (putting the taxpayer back in a loss position), the payroll tax election would once again be advantageous, and could be made on a superseding return.

How we can help

CLA’s R&D tax team can help your organization navigate and implement the Section 174 law change, which can be done on a standalone basis, or seamlessly during a research tax credit study.

Contact your CLA professional to learn how we can help your organization comply with these new rules.