IRS releases section 174 amortization guidance

by | Oct 10, 2023 | Tax Credits

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On September 8th, 2023, the IRS and Treasury released Notice 2023-63. This notice provides guidance on the amortization of specified research or experimental (SRE) expenditures under section 174. This was welcome news for taxpayers and practitioners who have been long awaiting guidance on several areas of uncertainty since the changes were introduced in the Tax Cuts and Jobs Act in 2017. It is important to note that taxpayers may rely on this guidance for tax years beginning after December 31st, 2021, or choose not to act on the guidance until final regulations are effective. However, even if a taxpayer chooses not to rely on the guidance until the final regulations are issued, they are still subject to the 174 amortization rules. Additionally, taxpayers are subject to 174 capitalization whether they claim a section 41 R&D tax credit.

Some of the key areas address in the notice include the following:

Cost Included as SRE:

  • Labor Costs – includes costs of full-time, part-time, and contract employees and independent contractors who perform, supervise, or directly support SRE activities. Other than severance pay, this includes basic compensation, stock-based compensation, overtime pay, vacation pay, holiday pay, sick leave pay, payroll taxes, pension costs, employee benefits, and payments to a supplemental unemployment benefit plan.
  • Materials and Supplies Costs – Costs of materials and supplies, including tools and equipment that are not depreciable under section 168, which are used or consumed in the performance of SRE activities or in the direct support of SRE activities.
  • Cost Recovery Allowances – Depreciation, amortization, or depletion allowances with respect to property used in the performance of SRE activities or in the direct support of SRE activities.
  • Patent Costs – Costs of obtaining a patent, such as attorneys’ fees expended in making and perfecting a patent application.
  • Operational and Management Costs – Rent, utilities, insurance, taxes, repairs and maintenance costs, security costs, and similar overhead costs with respect to facilities, equipment and other assets used in the performance of SRE activities or in the direct support of SRE activities.
  • Travel Costs – Travel costs for the performance of SRE activities or the direct support of SRE activities.

Cost Not Included as SRE:

  • Administrative Costs – Costs paid or incurred by general and administrative service departments (or functions) that only indirectly support or benefit SRE activities (for example, services of payroll personnel in preparing salary checks of research personnel, services of human resources personnel who hire research personnel, or services of accounting personnel who account for research expenses)
  • Interest on debt to finance SRE activities
  • Costs to input content into a website
  • Costs for website hosting
  • Costs to register an Internet domain name or trademark

Allocation of Costs to SRE Activities

 The allocation of certain costs such as rent, utilities, taxes, maintenance, and other overhead expenses has been a key area of uncertainty for taxpayers. Thankfully, the notice provides guidance that the allocation method for each cost type must be consistently applied and be based on a cause-and-effect relationship between the costs and the SRE activities or another relationship that reasonably relates the costs to the benefits provided to the SRE activities. For example, operational costs like rent, utilities, and insurance should also be allocated on the same basis as depreciation and labor costs could be allocated based on the portion of total time an employee spent on performing, supervising, or supporting SRE activities.

The examples provided in the notice sets forth that the following would be reasonable allocation methods:

  • Depreciation and other overhead costs are allocated by the department on the ratio of square footage occupied by the department to total square footage of the taxpayer.
  • Direct costs and allocated overhead costs of a department are included at the percentage of time a department spends on SRE.
  • Direct costs and allocated overhead costs of supporting departments are based on the percentage of time employees in each department spend on SRE activities.

Inclusion of Software Development Costs

The Notice provides welcome guidance on what constitutes software development activities. The list of software development activities includes, but is not limited to,

  • planning the development of, designing, and building a model of the computer software (or the upgrades and enhancements to such software);
  • writing source code and converting it to machine-readable code;
  • testing the computer software (or the upgrades and enhancements to such software) and making necessary modifications to address defects identified during testing;
  • In the case of computer software developed for sale or licensing to others (or the upgrades and enhancements to such software), production of the product master(s).

Software costs not includable in 174 include:

  • training activities;
  • maintenance activities after the software is placed in service that do not give rise to upgrades and enhancements (for example, corrective maintenance to debug, diagnose, and fix programming errors);
  • data conversion activities, except for activities to develop computer software that facilitate access to existing data or data conversion;
  • installation and other activities relating to placing the computer software in service.

Research Performed under Contract

The Notice addresses the uncertainty taxpayers faced evaluating treatment of a contract researcher’s (the research provider’s) costs under the mandatory amortization of 174 costs. The Notice provides detailed guidance on this topic, with the key takeaway being that the research provider is only subject to 174 amortization if they carry financial risk of the project or have the right to use or exploit the product derived because of the SRE.

The impact of Notice 2023-63 is dependent on each taxpayer’s facts and circumstances. KPT is available to help assist on how Notice 2023-63 impacts your tax liability. Please contact us today.

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