The tax treatment of research and experimental (R&E) expenditures changed this year, and taxpayers have waited all year for guidance from the IRS on how to comply with the new law. On December 12, 2022, the IRS finally issued guidance for businesses to use the automatic accounting method change procedures to begin capitalizing and amortizing research and development (R&D) expenses under Section 174.
The Tax Cuts and Jobs Act (TCJA) provides that for amounts paid or incurred in taxable years beginning after December 31, 2021, taxpayers are required to capitalize and amortize R&E expenses—including software development costs—and can no longer elect to deduct R&D expenses. As such, R&E costs must now be amortized over a period of five years for research performed in the U.S. and 15 years for research performed outside the United States. This applies to taxpayers regardless of whether the taxpayer historically claimed the R&D tax credit.
Accounting method changes generally require IRS consent; however, every year, the IRS publishes a list of accounting method changes that are eligible for automatic consent. For method changes not listed on this annual list, the taxpayer must submit Form 3115, Application for Change in Accounting Method, under the advance consent procedures, which require the specific approval of the IRS National Office.
In prior years, changes to the treatment of R&D expenditures under §174 were eligible for automatic change procedures. However, this year’s list of automatic accounting method changes in Revenue Procedure (Rev. Proc.) 2022-14 provides that the automatic method change procedures are not available for R&D expensing method changes under the new TCJA rules. As such, absent other IRS guidance, taxpayers were left with the only other option: file Form 3115 to obtain advance IRS approval to change their method of accounting for R&D expenses to comply with the TCJA. The new IRS guidance changes this.
New Guidance Issued by the IRS
Rev. Proc. 2023-08 modifies Rev. Proc. 2022-14 to allow companies to use the automatic consent procedures to change their method of accounting to capitalize and amortize R&D expenses to comply with the new §174 rules, as changed by the TCJA, for taxable years beginning after December 31, 2021. As such, taxpayers should file a statement with their original federal income tax return for the first taxable year in which §174 becomes effective in lieu of filing a Form 3115. The statement must include the following information for each applicant:
- The name and employer identification number or Social Security number of the applicant that paid or incurred specified R&E expenses after December 31, 2021;
- Beginning and ending dates of the first taxable year in which the change to the required §174 method takes effect for the applicant, e.g., year of change;
- The designated accounting method change number (DCN #265);
- A description of the type of expenditures included as specified R&E expenditures;
- The amount of R&E expenditures paid or incurred by the applicant during the year of change; and
- A declaration that the applicant is changing the method of accounting for specified R&E expenditures to capitalize such expenditures to a R&E capital account and amortize such costs over either five years for domestic research or 15 years for foreign research. The declaration also should state that the change is being made on a cutoff basis.
The requirement to file a duplicate copy of Form 3115 is waived for a taxpayer filing the statement in lieu of Form 3115.
If a change to the required §174 method for some or all of the taxpayer’s specified R&E expenditures is made for a taxable year subsequent to the taxable year of the taxpayer in which §174 becomes effective, the taxpayer should file a Form 3115 with a modified §481(a) adjustment that takes into account only specified R&E expenditures paid or incurred in taxable years beginning after December 31, 2021.
There is transition relief for taxpayers that filed a federal tax return on or before January 9, 2023 for a taxable year beginning after December 31, 2021. The transition rule provides that such taxpayers have complied with this guidance if they properly reported the amount of specified R&E expenditures on Part VI of Form 4562, Depreciation and Amortization, filed with the federal tax return, and properly capitalized and amortized such R&D expenses in accordance with §174, as amended by the TCJA.
Note that audit protection is not available for R&E expenditures paid or incurred in taxable years beginning on or before December 31, 2021. The IRS reserves the right to change the characterization or classification of R&D expenses to comply with Rev. Proc. 2023-8 and the new §174 rules under the TCJA for R&D expenses paid or incurred in each taxable year beginning after December 31, 2021.
These change procedures do not apply to a change in the treatment of acquired, leased, or licensed software under Rev. Proc. 2000-50, as modified by Rev. Proc. 2007-16 or a change in the treatment of R&E expenditures under former §174, or software development expenditures paid or incurred in taxable years beginning before January 1, 2022.
Potential Legislative Changes
Congress is currently negotiating an omnibus spending package to fund the federal government for fiscal year 2023. Part of these negotiations include potentially changing the expensing rules under §174 to defer the TCJA-amended rules into the future. If enacted as part of this year-end legislation, this change could potentially be retroactive to apply to taxable years beginning on or after December 31, 2021, which could make this IRS guidance obsolete. For updates on tax legislation and regulatory developments, subscribe to our Tax FORsights™ to receive the weekly issue of From the Hill.
There are numerous uncertainties regarding compliance with the new law. The IRS has stated it intends to issue technical guidance on this soon. It may not be easy for taxpayers to comply with this new law. In anticipation of the efforts required to capitalize R&E costs—including costs to develop software—under the new §174, businesses should begin in earnest identifying their R&E activities and the costs associated with those activities. This includes the direct costs—such as materials and wages—and costs incident to the R&E activities—such as overhead, indirect labor, depreciation, rent, etc. Businesses also should determine which costs relate to R&E activities performed within the U.S. and those outside of the United States.
Note, on December 29, 2022, the IRS issued Rev. Proc. 2023-11, which modifies and supersedes Rev. Proc. 2023-8 discussed above. Generally, the guidance remains the same, except that Rev. Proc 2023-11 adds that audit protection will not apply for expenditures paid or incurred in taxable years beginning after December 31, 2021, if a voluntary accounting method change is made for the taxable year immediately after the first taxable year in which § 174 becomes effective, e.g., calendar year 2023. Rev. Proc. 2023-8 provides that there is no audit protection for expenditures paid or incurred in tax years beginning on or before December 31, 2021.
If you have questions or need assistance implementing the new law for your business, please reach out to a professional at FORVIS or submit the Contact Us form below.