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Five Surprises About the U.S. Tax Research & Experimental Capitalization Requirement
Many were hopeful for U.S. tax legislation ensuring businesses could continue to fully deduct their research and experimental (“R&E”) expenditures in the 2022 taxable year. Senator Margaret Hassan (D-NH) introduced a bill as recently as March 16, 2023, to provide an immediate deduction related to Section 174 expenditures. However, the partisan Congressional divide will likely force businesses to reduce 2022 Section 174 R&E deductions to as little as 10% for domestic and 3.3% for foreign research.
Such a significant decrease in deductible expense is staggering compared to other countries, including China which provides a deduction 20 times higher than the U.S., or a 200% deduction, for R&E expenditures. While there is a strong disdain for Congress due to the lack of legislation, tax professionals and businesses are forced to gain a better understanding of the tax law surrounding Section 174 R&E expenditures and strive to strike a balance of practical application versus an overwhelming administrative burden. Unfortunately, the devil is in the details and may catch many taxpayers by surprise.
Surprise #1: Section 174 R&E Expenditures Are Not the Same Expenditures Evaluated for the Section 41 Research Credit
A reasonable assumption would be to review a business’s qualified research expenditures (“QREs”) under Section 41 and apply the capitalization policy under Section 174. However, this most likely would result in a gross understatement of Section 174 expenditures that must be capitalized. While it is true a Section 41 QRE must be included as a Section 174 capitalized expenditure, many more expenses could be captured under Section 174. Section 174 casts a much broader net and specifically includes pilot models and costs of obtaining a patent, neither of which are Section 41 QREs. Also, while Section 41 QREs only include 65% of contract research expenses, Section 174 provides that all contract research expenses are capitalized. Lastly, the definition of Section 174 expenditures include all such costs incidental to the development or improvement of a product. Therefore, indirect costs that are incidental to research must be included. Common examples include employee benefits, indirect labor costs, utilities, depreciation, and rent.
While the research credit is limited to direct research labor, supplies, and 65% of contract research, R&E expenditures under Section 174 are far more expansive, requiring a detailed analysis of a business’s trial balance to ensure the appropriate expenditures are captured.
Surprise #2: Internal & External Software Development Costs Need To Be Included
This surprise, and lack of guidance, has left many software developers scratching their heads. For purposes of the Section 41 research credit, software must be developed primarily for external use. However, Section 174 expenditures include any amount paid in connection with the development of software, whether for internal or external use. While Revenue Procedure 2000-50 provides guidance on the definition of software for Section 174, there is no definition of development under Section 174.
Under Rev. Procedure 2000-50, computer software is defined as any program or routine designed to cause a computer to perform a desired function or set of functions, and the documentation required to describe and maintain that program or routine. Computer programs of all classes, including operating systems, executive systems, monitors, compilers and translators, assembly routines, utility programs, and application programs, are considered software.
While many taxpayers can clearly identify software, whether they are developing software is a gray area. Section 174 expenditures activities are intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Court cases have provided some guidance when trying to understand “uncertainty” in the context of software development. The following questions should be discussed with your advisors to properly categorize Section 174 expenditures.
- Do the developers know exactly what steps to follow to create or design the product? Or is the development trial and error?
- Do the developers use proprietary software or software widely used?
- Do the developers utilize open-source software, or are they writing code from a blank slate?
Surprise #3: A Section 280C Election Is Probably Not Advantageous (Keep Reading!!)
Before January 1, 2022, many companies would make a 280C election for simplicity of adjusting taxable income for the research credit claimed. Without a 280C election, the amount of research credit reduced the amount of qualified research expenditures generating tax deductions when calculating taxable income. This requirement was burdensome and could cause headaches when filing state income tax returns. Alternatively, taxpayers could elect the 280C election, which allowed taxpayers to...
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