IRS Issues Guidance on Section 174 Ahead of Proposed Regulations
Sep 9, 2023
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Katherine Johnson, Esq
As business owners and tax professionals await action by Congress to delay or repeal the changes made to IRC § 174 by the Tax Cuts and Jobs Act (TCJA), the Internal Revenue Service (“IRS” or “the Service”) today issued interim guidance regarding the application of the law as it exists today. Notice 2023-63 provides direction on a number of topics that lacked clarity under § 174 and the outdated regulations currently in place.
Most notably, the guidance gives a detailed breakdown of the costs that must be included under § 174, termed “specified research or experimental (SRE) expenditures”, including:
- Labor costs of employees and contractors who perform, supervise, or directly support SRE activities;
- Costs of materials and supplies, including tools and equipment that are not depreciable under § 168, which are used or consumed in the performance of SRE activities or in the direct support of SRE activities;
- Depreciation, amortization, or depletion allowances with respect to property used in the performance of SRE activities or in the direct support of SRE activities, including property placed in service in a taxable year that begins on or before December 31, 2021;
- Costs of obtaining a patent;
- Rent, utilities, insurance, taxes, repairs and maintenance costs, security costs, and similar overhead costs with respect to facilities, equipment and other assets used in the performance of SRE activities or in the direct support of SRE activities; and
- Travel costs for the performance of SRE activities or the direct support of SRE activities.
The notice also gives example allocation methods for costs shared between SRE activities as well as general and administrative functions.
Regarding, the software development costs that § 174(c)(3) requires to be included, the IRS clarified a number of activities that constitute software development as well as specifically including software “developed for use by the taxpayer in its trade or business,” typically referred to as internal-use software (IUS). The Service did note that the purchase, installation, and configuration of commercially available software is not included under § 174(c)(3).
Additionally, the notice clarifies which taxpayer should be capitalizing and amortizing research performed under contract. Generally, the approach taken is that a funding analysis, similar to that required under IRC § 41, should be performed. The application, however, differs from § 41: a “research provider” must capitalize and amortize SRE expenditures if under the terms of the contract that taxpayer bears financial risk or retains the “right to use any resulting SRE product in the trade or business … or otherwise exploit any resulting SRE product through sale, lease, or license.”
The notice also discusses and provides examples for the application of code sections that are impacted by the changes in § 174, including § 460, regarding how to apply the percentage-of-completion method (PCM) to account for income from long-term contracts when allocable contract costs include SRE expenditures, and cost-sharing regulations found in § 1.482-7, which deal with the application of § 174 to US parent companies with foreign subsidiaries where there is both domestic and foreign development.
As stated in the notice, this is interim guidance. The Treasury Department and the IRS seek input from taxpayers before the proposed regulations are published. Section 11 of the notice lists a series of specific questions and areas for clarification that remain open-ended. Any written comments should be submitted by November 24, 2023.
CTI looks forward to a more complete discussion of the interim guidance and its impacts on businesses in an upcoming blog post. If there are any questions we can answer or assistance we can provide, please reach out to our team of engineers, CPA, and attorneys.
