Identification of section 174 expenditures
The first main area the AICPA comments on is the identification of R&E expenditures. Many taxpayers that pay or incur section 174 expenditures may not have established methods for identifying them since they could be expensed under section 174 or deducted as ordinary business expenses prior to 2021.
The existing section 174 regulations do not define various categories of expenses, including direct and indirect costs, and whether they fall within the definition of R&E expenditures. Rather they provide a general standard for identifying R&E expenditures based on the nature of the activity to which the expenditures relate. This is contrast to the regulations for the research credit under section 41 which clearly define the costs eligible for the credit.
AICPA recommendations for identification
The AICPA recommends that any Treasury and IRS guidance:
- Provide that the definition of R&E expenditures for section 174 include direct costs, including employee compensation, contract labor, and materials, and, at the taxpayer’s election, allocable indirect and overhead costs, and
- Provide detailed examples that illustrate which costs are “incident to” the development or improvement of a product.
The AICPA comments argue that there is no indication from Congress that the mandatory amortization rules for post-2021 expenditures should apply to all indirect costs unlike the uniform capitalization rules under section 263A. Instead, the AICPA argues that indirect costs such as overhead and administrative costs should not be required to be allocated for purposes of identifying R&E expenditures. Instead, taxpayers should be permitted to allocate such expenses on an elective basis only when needed to clearly reflect income.
Software development costs
- expensed immediately and deducted in the year paid or incurred like R&E expenditures under section 174, or
- amortized and deducted ratably over a period of at least 60 months from the date of development was completed, or over 36 months from the date depreciable software was placed in service.
Automatic consent procedures are provided under Rev. Proc. 2000-50 and Rev. Proc. 2022-14 for a taxpayer to change their method of accounting for this purpose. The AICPA noted, however, that uncertainty exists whether a taxpayer is precluded from using the consent procedures for the post-2021 rules.
Automatic consent procedures limited
Rev. Proc. 2000-50 provides that the options for treating software developmental cost do not apply to costs that the taxpayer has already consistently applied as R&E expenditures under section 174 or amortizable as section 197 intangibles. The automatic consent procedures also must be implemented on a cut-off basis rather than with a section 481(a) adjustment.
It may not be clear to a taxpayer whether some of its costs were consistently applied as R&E expenditures under the pre-2022 rules. For example, a taxpayer that historically treated the costs as immediately expensed may not have identified whether it deducted those the costs under section 174 or as an ordinary business expense under section 162. Similarly, if taxpayer previously used the consent procedures to immediately expense its R&E expenditures it would preclude them from making any subsequent change.
In both cases, the AICPA argues that the IRS did not intend to prohibit the taxpayers from using the consent procedures to change their accounting methods based on their present method of account. Thus, the AICPA that the IRS modify the automatic consent procedures to clarify that the limit on R&E expenditures only applies to costs previously subject to an irrevocable election under section 174.