Ryan J. McDonell, CPA, MSA
Tax Manager
The IRS on September 8, 2023, issued preliminary guidance on the amortization of research expenses and announced forthcoming proposed regulations related to tax treatment of Sec. 174 specified research or experimental (SRE) expenditures.
This long-awaited guidance will affect business taxpayers who have SRE expenditures (commonly known as research and development) for the 2022 tax year and beyond. We recommend that affected taxpayers familiarize themselves with with the guidance in IRS Notice 2023-63 as they prepare for the next tax season.
Background
Prior to the 2022 tax year, taxpayers were generally permitted to deduct Sec. 174 specified research or experimental (SRE) expenditures as current deductions in the year paid or incurred. Taxpayers were also permitted, but not required, to amortize these research costs over time or to charge these costs to capital accounts. In most instances, taxpayers opted to deduct SRE expenditures as current costs to immediately reduce taxable income.
The 2017 tax law commonly known as the Tax Cuts and Jobs Act (TCJA) changed the treatment of SRE expenditures beginning with the 2022 tax year. Starting in 2022, taxpayers must capitalize and amortize research costs over a five-year period for domestic research costs or over a 15-year period for foreign research. The amortization requirement delays the deduction of research costs, causing taxpayers with SRE expenditures to have increased taxable income.
IRS Guidance Notice 2023-63
The IRS in September issued Notice 2023-63 to provide preliminary guidance on the amortization of research expenses and to announce forthcoming proposed regulations. The guidance explains that domestic SRE expenditures must be capitalized and amortized over a five-year (60-month) period beginning with the midpoint of the taxable year in which such expenditures are paid or incurred. Accordingly, a taxpayer is only allowed a deduction of 10% of SRE expenditures during the first year paid or incurred (six of 60 months during year one), 20% in years two through five (12 of 60 months each year two through five), and 10% in the sixth year (six of 60 months remaining year six):
Example:
A taxpayer incurs $100,000 of SRE expenditures during the 2023 taxable year. The taxpayer must capitalize and amortize the SRE expenditures over a 60-month period beginning with the first day of the seventh month during the taxable year. The taxpayer may deduct the expenses as follows:
| 2023 | 2024 | 2025 | 2026 | 2027 | 2028 |
Amortization Percentage | 10% | 20% | 20% | 20% | 20% | 10% |
Deduction Amount | $10,000 | $20,000 | $20,000 | $20,000 | $20,000 | $10,000 |
SRE expenditures generally include research and development costs, costs incidental to the development or improvement of a product (indirect costs), and costs in connection with the development of software. Expenditures for research carried on by another person or organization on behalf of the taxpayer (third-party research) are also SRE expenditures if the taxpayer bears the risk. The IRS guidance provides a non-exhaustive list of examples of costs that are and are not SRE expenditures. Some standout items include the following:
Costs treated as SRE expenditures:
- Labor costs
- Materials and supplies
- Cost recovery allowance (depreciation, amortization and depletion)
- Patent costs
- Certain operation and management costs
- Travel costs
Costs not treated as SRE expenditures:
- General & administrative departments only indirectly supporting SRE activities
- Interest on debt to finance SRE activities
- Website hosting costs
- Quality control testing
Affected taxpayers are encouraged to reference sections 4.03(1) and 4.03(2) of Notice 2023-63 for more detail on the above costs and additional examples.
Taxpayers must allocate a portion of indirect costs to SRE activities based on a cause-and-effect relationship between the costs and the SRE activities. Different allocation methods may be used for different costs, but methods should be applied consistently for each type of cost. The notice gives an example of allocating costs between different departments (i.e., research department, legal department and engineering department). Costs incurred by the research department are fully included in SRE expenditures, while costs incurred by other departments are further allocated based on a ratio of hours worked on research activities to total hours worked, or square footage used for research activities to total square footage.
If property is disposed, for example by sale or abandonment, during the amortization period, a taxpayer must generally continue to amortize the SRE expenditures instead of immediately deducting any unamortized amounts. Only when a corporation ceases to exist for federal income tax purposes without a successor corporation taking over its tax attributes may a corporation deduct any unamortized SRE expenditures in its final taxable year.
Change on the (distant) horizon
Multiple bipartisan efforts to revert to allowing immediate expensing of SRE expenditures have been floated in both chambers of Congress, including H.R. 2673 American Innovation and R&D Competitiveness Act of 2023 and S. 866 American Innovation and Jobs Act. Congressmembers continue to signal support for this change, with the delay appearing to stem from a lack of appropriate legislative vehicle as well as disputes over concessions. Recently, several members of Congress have suggested that meaningful tax legislation may not move until 2025 after the next presidential election. In the interim, taxpayers should familiarize themselves with the current SRE expenditure ruleset and keep an eye out for forthcoming guidance.
If you have questions about the tax treatment of SRE expenses in your organization, contact your G.T. Reilly advisor.