IRS Releases Guidance on the Requirement to Capitalize Research and Experimental Expenditures

On Friday, September 8, 2023, the Treasury Department and Internal Revenue Service (collectively the IRS) released Notice 2023-63 (the Notice) (https://www.irs.gov/pub/irs-drop/n-23-63.pdf, providing interim guidance to address three matters.  The Notice also indicates that the IRS intends to issue rules in forthcoming proposed regulations consistent with this interim guidance.

Items addressed in the notice are:

1. The capitalization and amortization of specified research or experimental (SRE) expenditures under Section 174 of the Internal Revenue Code amended under the 2017 legislation commonly referred to as the Tax Cuts and Jobs Act (TCJA);
2. The treatment of SRE expenditures under the long-term contract rules of Section 460; and
3. The application of Section 482 to cost-sharing arrangements involving SRE expenditures.

The first item has been keenly awaited by taxpayers and their advisors, as the capitalization requirements have been known about since December 2017 and since they are already required for the 2022 calendar year (for which likely most returns have already been filed or due September/October 15, 2023). While research and experimental costs could be fully deducted in the year incurred or paid prior to 2022, these same costs are now required to be amortized over a five-year period for U.S.-sourced costs or over a 15-year period for foreign expenditures. 

Section 4 provides taxpayers with clarity in determining whether expenditures are SRE expenditures subject to capitalization and amortization under Section 174 (while Section 5 provides rules specific to software development). The general focus of this article is to highlight some of the general provisions contained in Section 4. 

At an executive level, the Notice provides definitions and rules for complying. The Notice reminds us by reference that specified research or experimental expenditures (SREE) are costs incurred in a taxpayer’s trade or business in the experimental or laboratory sense incident to the development or improvement of a product if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product (pilot model, process, formula, invention, technique, patent or similar property).  The ultimate success, failure, sale, or use of the product is not relevant to a determination of Section 174 qualification.

The Notice also clarifies that SREEs include “all costs” incident to the development or improvement of a product (or components and subcomponents). The notice includes a “non-exhaustive” list of examples of the types of costs that are SREEs, including:

a) Labor costs (includes all elements of compensation such as vacation pay, payroll taxes, pension costs and other employee benefits),

b) Materials and supplies,

c) Cost recovery allowances (depreciation, amortization, and depletion),

d) Patent costs,

e) Certain operating and management costs (rent, utilities, insurance, taxes, repairs and maintenance, security costs and other similar overhead costs with respect to facilities and assets used in the performance of research activities and in the direct support of research activities), and

f) Travel costs.

Interest expense incurred to finance research activities is not a cost requiring capitalization under Section 174. Some other costs not requiring capitalization include expenditures for quality control, advertising, and promotion.

The Notice also provides guidance on methods to allocate costs to research activities based on a “cause-and-effect” relationship. Allocation methods can be different between types of costs; however, the method chosen must be consistent for each type of cost. For example, labor costs could be allocated based upon a ratio of time, while facility cost recovery allowances could be determined by a ratio based upon square footage. 

Finally, Section 4 provides a comprehensive example of cost allocation for a taxpayer with six different departments (manufacturing, research, engineering, legal, personnel and accounting) where both direct and indirect costs are incurred on research projects. 

While the Notice is not intended to change the eligibility rules for qualifying for the research and development credit, the Notice does provide guidance regarding expenditures that are treated as SRE expenditures under Section 174 and, therefore, affects expenditures that may be treated as SRE expenditures for purposes of calculating the research tax credit. 

Also, the Notice is not the last word on the capitalization requirements. Proposed regulations are forthcoming. Further, the Notice provides that the IRS is continuing to study issues not addressed in the Notice and is also requesting comments on issues arising from the interim guidance that is expected to be addressed in regulations. 

Finally, the IRS anticipates the forthcoming proposed regulations will apply for taxable years ending after September 8, 2023. However, a taxpayer may choose to rely on the rules described in the Notice, provided they are applied in a consistent manner. However, the capitalization requirements of Section 174 apply even when a taxpayer chooses not to rely upon the guidance in the notice. 

If you have questions regarding research and experimental costs required to be capitalized, and how to potentially minimize the impact on taxable income by considering whether your activities qualify for a research credit please don’t hesitate to reach out to Schneider Downs. While staying current in tax credits and economic development incentives can be daunting, our tax professionals are fully committed to assisting you in identifying and securing the tax credits and incentives available to you and your business. Contact one of our R&D Tax Credit experts or learn more on our dedicated R&D landing page.