Prior to January 1, 2022, taxpayers had options regarding how R&E expenditures were handled for tax reporting purposes. At the time, IRC §174 provided options for R&E treatment. The popular option was the immediate expensing of qualified R&E expenditures in the same year the costs were incurred. Alternatively, R&E expenditures could be amortized over 5 years. Taking an immediate deduction often significantly reduced federal income taxes. As such, the amortization option saw limited use. Additionally, IRC §41 provides for the R&E Tax Credit. The credit allows for a percentage of qualifying R&E expenditures to be used in a dollar-for-dollar offset of federal income taxes. Taxpayers often combined immediate expensing with the credit, allowing for significant deductions in the year(s) R&E expenses were paid or incurred.
The option for immediate expensing of qualified R&E expenditures no longer exists. The Tax Cuts and Jobs Act of 2017 contained a provision mandating specific R&E treatment. In tax years beginning on or after January 1, 2022, qualifying R&E expenditures must be capitalized and amortized over a 5-year period (15 years for foreign activities). This mandatory capitalization also applies to software development costs, regardless of intended use (commercial or internal). The amortization period begins at the midpoint of the taxable year in which the R&E expenses were paid or incurred, effectively limiting deduction to 10% in the tax year the expenses were paid or incurred.
IRS released Rev. Proc 2023-11 in December 2022 to provide guidance on automatic procedures for taxpayers to change their method of accounting to implement the new capitalization and amortization requirement. Instead of filing Form 3115 (Application for Change in Accounting Method), taxpayers can file a statement with their return containing:
- The name and employer identification number or social security number of the taxpayer
- The beginning and ending dates of the first taxable year in which the change to the required IRC Section 174 method takes effect for the taxpayer
- The designated automatic accounting method change number for this change (265)
- A description of the type of costs included as specified R&E expenditures
- The amount of specified R&E expenditures paid or incurred by the taxpayer during the year of change
- A declaration that the taxpayer is changing the method of accounting for specified R&E expenditures to capitalize such expenditures to a capital account and amortize such amount over either a five or 15-year period beginning with the mid-point of the taxable year in which such expenditures are paid or incurred
- A statement that the above-listed changes are being made on a cut-off basis
The R&E Tax Credit is not impacted by the amortization requirement. Taxpayers can still claim the R&E Tax Credit for qualifying R&E expenses. Additionally, the requirement does not have an impact on Generally Accepted Accounting Principles (GAAP) treatment of R&E costs. However, businesses will potentially experience significant timing differences between financial statement and tax return reporting for the life of R&E expenses. These differences may generate impacts for deferred tax provisions.
Please contact the professionals at Gilliam Bell Moser if you have any questions.