New Guidance on Research and Experimental Expenses – Understanding IRS Code Sec. 174 for Effective Compliance

Research and Experimental (R&E) expenses incurred in the years starting after 12/31/2021 must be capitalized and amortized over 5 and 15 years for US and foreign research respectively.  Taxpayers must look at where the activities are performed to determine whether the corresponding expenditures are attributable to foreign research. 

Capitalization and Amortization Criteria

There is a mid-year convention for amortization in year one – that is amortization is ½ of the usual amount, as all the costs are assumed to be incurred on July 1st of that tax year, the mid-point. 

Any development of computer software are capitalizable expense. 

Expense Classification

A notice giving detailed guidance on how to compute such expenses has been recently issued.  It provides detailed information on the application of these rules. 

Allocation Methods and Consistency

The costs must be allocated based on the cause-and-effect relationship between the costs and the R&E activities or any other reasonable method.  The allocation method used for each type of cost must be applied on a consistent basis. Specific examples include allocating labor costs by time spent and allocating rent by footage used. 

Software Development Expenses

Computer software includes a computer program, a group of programs, and upgrades and enhancements. 

The term upgrades and enhancements generally means modifications to existing computer software that result in additional functionality (enabling the software to perform tasks that it was previously incapable of performing), or materially increase the speed or efficiency of the software.

Financial Risk and Disposal of Property

If the research provider bears financial risk under the terms of the contract with the research recipient, then relevant costs are capitalized. Even if the research provider does not bear financial risk, but has the right to benefit from the research, the relevant costs still need to be capitalized. 

When the property is disposed of or retired, no immediate deductions for the amount of unamortized costs.  Must continue amortizing on the same schedule. However, if a corporation liquidates, the deduction for unamortized costs can be taken that same year. 

Expected Changes and Comments

The Congress has been trying to cancel these rules for four years and may do so at any time. 
Remember, tax laws are complex and subject to change. Consult a qualified tax professional to ensure you’re compliant with all regulations and optimize your tax savings. So, utilize marketplaces like IfindTaxPro where you can post your project and find the right tax specialist.