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Tax & AccountingJune 27, 2022

AICPA makes recommendations on guidance for section 174 amortization of R&E expenditures

By: CCH AnswerConnect Editorial

The American Institute of Certified Public Accountants (AICPA) has issued comments regarding the need for IRS guidance on the amortization of research and experimental (R&E) expenditures under Code Sec. 174. For tax years beginning in 2022, R&E expenditures may no longer be immediately expensed but rather must be amortized over five years (15 years for foreign expenditures). 

In a May 26, 2022, letter to the IRS, the AICPA specifically requested guidance and provided recommendations on:

  • identification of categories of section 174(a) expenditures, and 
  • issues related to the treatment of costs paid or incurred to develop, purchase, or lease computer software as previously outlined under Rev. Proc. 2000-50. 

Amortization of section 174 expenditures

For tax years beginning before 2021, a taxpayer could elect to expense and immediately deduct R&E expenditures, amortize them over five years, or capitalize them to related property. Rev. Proc. 2000-50 provided special rules for taxpayers to elect to treat software development costs like R&E expenditures (other than capitalization) whether they met the section 174 requirements or not.

The Tax Cuts and Jobs Act (TJCA) (P.L. 115-97) modified the section 174 rules and beginning in 2022, taxpayers may no longer currently deduct R&E expenditures but instead must amortize specified R&E expenditures ratably over five years  (or 15 years for foreign expenditures). Software development costs are expressly included in the definition of specified R&E expenditures after 2021. They were not included in the definition of R&E expenditures under the pre-2022, but only treated similarly to R&E expenditures through Rev. Proc. 2000-50.

Guidance sought in lieu of legislative changes

The required amortization of post-2021 research and experimental expenditures is a departure from the generally accepted accounting principal (GAAP) rules that requires most research and development costs to be expensed immediately. The changes were included as a revenue raiser for the federal government to help pay for other tax breaks in the TJCA legislation. 

There has been discussions in Congress to postpone the TJCA changes to section 174 or repeal them entirely and restore the rules allowing immediate expensing of R&E expenditures. However, these discussions have stalled so far. Without any legislative relief, the AICPA is seeking guidance from the Treasury and IRS on implementation of the mandatory amortization post-2021 changes. Such guidance is needed immediately for the 2022 tax year, especially for corporations that must prepare financial statements.

Without any legislative relief, the AICPA is seeking guidance from the Treasury and IRS on implementation of the mandatory amortization post-2021 changes.

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

The second main area the AICPA comments on is the treatment of software development costs under Rev. Proc. 2000-50. The revenue procedure provides that such costs may be:

  • 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. 

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