Co-authored by R&D Incentives Group Sr. Manager Farrell Gerbode
With the upcoming 2022 tax compliance deadline, one item that is hitting taxpayers hard is the mandatory Section 174 capitalization rules. What makes it worse is the little guidance provided by regulatory authorities around the scope of Section 174, especially around some of the indirect costs.
WHAT IS SECTION 174?
IRS Code Section 174 has been described as broad and vague. There has been speculation that additional guidance would be provided by regulatory authorities and that the IRS could potentially repeal this mandatory capitalization provision which some consider aggressive on taxpayers with research & development (R&D) activities. Despite the looming fall filing season, taxpayers are still grappling with limited guidance from the IRS, U.S. Treasury and courts regarding the applicability of Section 174 to specific expenditure categories.
While the regulatory history shows long-term efforts to broadly define Section 174 research and experimentation (R&E) expenditures, little has been offered to guide taxpayers in the identification of eligible costs. This is especially true regarding the appropriate scope of “indirect” (e.g., ancillary) development costs that taxpayers are required to include. This is particularly impactful as taxpayers are unable to realize a current deduction for R&E expenditures, so may incur an unforeseen tax liability.
WHAT ARE SECTION 174 EXPENDITURES?
Section 174 R&E expenditures are defined as “research and development costs in the experimental or laboratory sense.” Such costs are incurred in connection with a taxpayer’s efforts to resolve uncertainties surrounding the development, design or improvement of a product.
- Per Treasury regulations, it is expected that R&E expenditures “generally [include] all such costs incident to the development or improvement of a product.” Note that this contrasts sharply with the more restrictive definition of qualified research expenditures for purposes of the Section 41
- Further expanding Section 174’s reach, the term “product” is defined to include any pilot model, process, formula, invention, technique, software, patent or similar property that the taxpayer’s business uses internally or holds for sale, lease or license.
- Both direct and indirect R&E expenditures are eligible under Section 174, provided that the amounts incurred are reasonable under the circumstances. Direct costs include the cost of materials, labor and third-party services related to research activities. Indirect costs include overhead costs incidental to the development effort.
- Indirect costs can potentially be quite significant, but guidance on the proper scope and allocation of indirect costs is severely lacking.
WHAT GUIDANCE EXISTS REGARDING THE INCLUSION OF INDIRECT COSTS?
Examples of the limited available guidance on the inclusion of indirect costs include:
- Rev. Rul. 73-275 (issued 1973) clarifies that “all costs” include both the direct and indirect costs of research and development, determining that a taxpayer was eligible to deduct the unspecified “overhead” costs of its product development department in addition to salaries of the relevant employees.
- Rev. Rul. 73-20 (issued 1973) clarifies that “administrative costs” incurred in connection with a development project constituted Section 174 expenditures.
- Treas. Reg. § 1.174-4(c)
identifies “heat, light and power” as potentially eligible.
- In Kilroy v. Commissioner (U.S. Tax Court 41 TCM 292, TC Memo. 1980-489) the court notes that “utility expenses, such as the telephone, travel expenses…” are all eligible R&D expenditures under Section 174.
While helpful, the available guidance leaves many open issues surrounding the inclusion of indirect development costs with Section 174 R&E expenditures. Taxpayers are still in need of a more consistent and thorough framework which can be consistently applied.
- In the absence of sufficient guidance from the tax perspective, many taxpayers have looked toward financial accounting rules for a more complete set of principles to apply.
- Foremost among these is ASC 730-10-25-2, which states that research costs “shall include a reasonable allocation of indirect costs. However, general and administrative costs that are not clearly related to research and development activities shall not be included.”
- In the absence of formal tax guidance, this principle provides a practical cutoff point for the allocation of indirect costs. This is achieved through the requirement that the indirect costs included must bear a clear relationship to the R&E activities.
FREQUENTLY ASKED QUESTIONS ABOUT SECTION 174
Are payroll taxes and other employee overhead costs eligible for amortization under Section 174?
Employee overhead costs are an indirect component of the R&E labor costs that taxpayers must amortize under Section 174. Common examples of these costs include vacation pay, sick pay, payroll taxes and payments to a supplemental unemployment plan. These costs are directly attributable to employee wage payments and thus clearly relate to the R&E activities performed.
Are property taxes eligible for amortization under Section 174?
Property taxes are incurred because of building ownership and are determined as a function of building value. They do not tie to any particular R&E activities performed within the building and would continue to be incurred at the same rate even if R&E activities within the building ceased. Since they share no clear relationship to the R&E activities performed, they do not constitute an indirect Section 174 cost.
Are facility insurance costs eligible for amortization under Section 174?
Unless the insurance is specifically related to the nature of the development work performed within the facility (e.g., fire insurance for pyrotechnics developers), no clear relationship exists between the insurance costs and the R&E activities performed. As a result, facility insurance costs do not constitute an indirect Section 174 cost.
Are software development costs eligible for amortization under Section 174?
Yes — in fact, this is one of the few areas specifically addressed by available guidance. Section 174(c)(3) requires that any
cost incurred in connection with the development of any software must be treated as R&E expenditures, and consequently amortized under Section 174. For financial purposes, however, taxpayers may continue to use the amortization or deduction schemes they had in place previously. Note that consulting fees associated with administrative/training costs for software migration/installation/modification may not be subject to Section 174 capitalization.
WHAT ARE SOME LESSER-KNOWN TAX PLANNING IMPLICATIONS OF SECTION 174?
Major financial impact of outsourcing development work overseas: Under the revisions to Section 174 that took effect for tax years beginning after 12/31/2021, taxpayers must amortize domestically incurred R&E expenditures over a 5-year period. Foreign R&E expenditures, however, are subjected to a significantly longer 15-year amortization period. A company that consistently incurs a substantial amount of foreign R&E expenditure annually (such as those that rely heavily on overseas software development teams), could potentially be burdened with a substantial increase in taxable income over the next 15+ years, until the amount of amortized deductions available annually “catches up” to the company’s annual development spend. Before entering into (or continuing) such an arrangement, taxpayers will need to weigh the benefits of offshore development against the increase in tax liability that may result.
Drawbacks to Section 280C(c) reduced credit election for R&D credit filings: In addition to revamping Section 174, the Tax Cuts and Jobs Act of 2017 also made significant changes to Section 280C, making the §280C(c) reduced credit election less advantageous for the majority of R&D tax credit filers. As revised, the “add back” of the research credit to income is now only performed to the extent that the credit exceeds the amortized R&E deduction amounts available for the year whereas previously there was no threshold, and the entire credit was required to be added. Because Section 174 is broad, the amortized amount is generally more than the actual credit claimed under the narrow definition of Section 41; as a result, taxpayers who forego the reduced credit election will often be able to apply a greater portion of the benefit generated than the 79% the reduced election affords.
The above list is not all-inclusive and is provided to demonstrate examples of the ambiguity around the scope of Section 174. For any questions about Section 174 eligibility and its impact on tax liability, please contact the Tax Services Team
at GHJ. We partner with R&D Incentive Group on a detailed review of Section 174 analysis, especially if it has a significant cash impact on our clien