Implications of the Tax Cuts and Jobs Act (TCJA) on Sections 174, 41 and 280C
Prior to the enaction of the Tax Cuts and Jobs Act (TCJA) on December 22, 2017, Section 174 of the Internal Revenue Code allowed taxpayers to currently deduct ‘research or experimental’ (R&E) expenditures. Alternatively, taxpayers could elect to treat R&E as deferred expenses that are deducted ratably over at least 60 months or as capital expenditures that are amortizable over a useful life, if determinable. Under Section 59(e), taxpayers choosing to deduct R&E expenditures could also annually elect to recover the costs over a 10-year period. Following Rev. Proc. 2000-50, taxpayers with software development costs could deduct such costs currently, capitalize and amortize over five years, or capitalize and amortize over three years—regardless of bonus depreciation.
Implications of the TCJA
For tax years beginning after December 31, 2021, the TCJA amended Section 174 to eliminate these options and require taxpayers to capitalize R&E expenditures and software development. Capitalized costs are required to be amortized over five years for domestic research expenditures, or 15 years for expenditures attributable to foreign research. Because costs that may be claimed under the R&E tax credit under Section 41 must be eligible costs under Section 174, it is expected that any amounts treated as qualified research expenditures by a taxpayer for purposes of the R&E credit also will be capitalized under the changes made by the TCJA. The change to Section 174 does not impact the calculation of the R&E tax credit under Section 41.
The TCJA requires that the change in treatment of R&E expenditures under Section 174 be treated as a change in accounting method that should be made on a cutoff basis for costs paid or incurred as of the first day of the tax year of change. There is no need for adjustments to the treatment of R&E expenditures incurred in prior years. Rev. Proc. 2023-11 made clear that the application of these amendments is to be treated as a change in method of accounting under Section 481 but will be treated as an automatic change. Therefore, a statement attached to the taxpayer’s return will be accepted in lieu of a Form 3115 filing.
Treas. Reg. § 1.174-2 continues to provide the definition of R&E expenditures and now includes the addition of software development expenditures to be expressly treated as specified research. The TCJA terminates the alternative amortization method for software development expenses otherwise eligible for deduction under Rev. Proc. 2000-50 and now requires capitalization of software development expenses over at least five years.
Implications to the Application of Section 280C
The TCJA amended Section 280C by removing references in former Section 280C(b)(2), to a “Similar rule where taxpayer capitalizes rather than deducts expenses.” This is no longer relevant as now the only permissible method of treating R&E costs is capitalization and amortization. Taxpayers must consider their comprehensive tax posture when deciding on whether to make a section 280C(c)(2) election to claim a reduced rate of credit in lieu of a reduction in deductions. Taxpayers must also be certain that it is permissible to make the election under section 280C(c)(1).
If Section 280C(c)(1) applies, taxpayers that previously elected the reduced credit to minimize total tax liability may find that capitalization allows the full credit to provide a lower total tax liability for the current year while increasing tax liability for future years.
While XBS does not perform comprehensive Section 174 analyses, we can assist our clients in determining areas within their organization that should be considered for such treatment.