The tax landscape for companies conducting research and experimental development (R&D) has undergone significant changes with the implementation of Section 174. Enacted in 1954 as part of the Internal Revenue Code (IRC), Section 174 was designed to provide clarity and incentives for businesses engaging in R&D activities. However, recent updates to Section 174, as outlined in the 2017 Tax Cuts & Jobs Act, have introduced new capitalization requirements that impact how R&D expenses are treated for tax deductions.

Here, we will explore the key aspects of Section 174 capitalization, including which entities are subjected to these requirements, the types of expenses that qualify for capitalization, and the implications for financial statements and tax liability. Additionally, we will address some of the implementation challenges faced by taxpayers and provide insights into the impact of Section 174 on software-based startups.

Section 174 Capitalization: An Overview

Section 174 allows businesses to either deduct or amortize certain R&D costs. Deductions can be made in the year in which they are paid or incurred, or they can be amortized over a period of not less than 60 months. However, with the recent changes to Section 174, companies are now required to capitalize and amortize their R&E expenses over 5 or 15 years, depending on whether the expenses are domestic or foreign.

Entities Subjected to Section 174 Capitalization

Section 174 applies to any taxpaying entity that incurs qualifying R&D costs, regardless of industry or business size. The following types of businesses are particularly impacted:

• Corporations: Regardless of size, corporations that incur qualifying R&D costs are subjected to Section 174 capitalization.

• Small businesses and startups: Small businesses and startups heavily invested in R&D may capitalize or amortize their research expenses, irrespective of their current profitability status.

• Sole proprietorships, partnerships, and LLCs: These entities can also take advantage of Section 174 if they have qualifying R&D expenses.

• Pass-through entities including S-corporations: Pass-through entities can utilize Section 174 for eligible costs associated with R&D, and the R&D credits can be passed through partners, individual shareholders, or members.

Qualifying Expenses for Section 174 Capitalization

Section 174 covers a broad range of expenses related to research and experimental development. These expenses can be categorized into direct and indirect costs.

Direct Costs

• Salaries and wages: The salaries and wages of employees directly involved in conducting, supervising, or supporting research activities can be capitalized.

• Supplies and materials: The cost of supplies used in the research process, including lab equipment and required software, can be capitalized.

• Patent costs: Expenses related to obtaining patents for products or processes developed through research activities are eligible for capitalization.

• Contract research expenses: If a third party is hired to research on behalf of a company, the cost of the contract research can be capitalized.

Indirect Costs

• Overhead expenses: Certain indirect expenses, such as utilities for research labs or depreciation on research equipment, can be allocated to research activities.

• Attorney fees for patents: Legal expenses incurred in the process of making and perfecting patents are eligible for capitalization.

Exclusions from Section 174 Deductions

While Section 174 allows for the capitalization of various R&D expenses, there are certain exclusions to consider. Expenses for land or depreciable properties are not deductible under Section 174. Additionally, costs associated with research conducted after the beginning of commercial production, marketing research, quality control, and funded research are generally excluded from Section 174 deductions.

Defining R&D for Section 174 Purposes

To qualify for the R&D credit under Section 174, the research must meet a four-part test established by the Internal Revenue Service (IRS):

• Business purpose: The research must be intended to benefit a business component, such as a product, process, software, technique, formula, or invention that the company plans to use in its trade or business.

• Technological in nature: The development of the business component must be based on a hard science, such as engineering, physics, chemistry, life or biological sciences, or computer sciences.

• Elimination of uncertainty: The research activity must aim to discover information that would eliminate uncertainty about the development or improvement of a product or process.

• Process of experimentation: The business must evaluate multiple design alternatives or employ a systematic trial-and-error approach to overcome technological uncertainty.

State Conformity to Section 174

Companies must consider state conformity to Section 174 when filing their taxes. States vary in their conformity to the IRC Section, adopting changes on a rolling basis or a static basis. Some states, like Illinois, New Jersey, New York, and Pennsylvania, conform on a rolling basis, automatically adopting federal tax code changes. Others, such as Florida, Georgia, Virginia, and North Carolina, conform on a static basis, adopting the federal tax code as of a specific date. Some states have selective conformity, adopting specific portions of the IRC.

It is important to note that levels of conformity can vary by state and may be subject to adjustments, additions, or exceptions based on individual state tax laws. Companies should consult with tax professionals or check with the specific state they are filing in to determine the extent of conformity to Section 174.

Implications of Section 174 Capitalization

The changes to Section 174 have significant implications for both financial statements and tax liability. Companies must understand the impact of these changes and prepare accordingly.

Financial Statement Impact

The new Section 174 rules require the capitalization and amortization of R&D expenses, resulting in new book-tax differences and related deferred tax assets. This can have material impacts on financial statements, especially when considering the potential effects on other tax calculations. Effective tax rates may be affected, and companies should be prepared to account for these changes in their financial statements.

Tax Liability Considerations

With the implementation of Section 174 capitalization, companies will need to adjust their tax compliance, planning, and payment processes. The capitalization and amortization of R&D expenses can impact various tax computations, including interest expense limitation under Section 163(j), state and local tax reporting, treatment of R&D payments between related parties, computations under foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI) regimes, and determination of excludable Section 174 costs for Section 263A purposes.

Companies should review their tax provisions and tax return filing processes to ensure compliance with the new capitalization rules. It is crucial to develop an approach that accurately reflects the changes introduced by Section 174 and consider the potential tax implications.

Implementation Challenges and Considerations

Implementing the new Section 174 rules presents several challenges and considerations for taxpayers. As the rules are relatively new, guidance from Treasury and the IRS is limited. Taxpayers must navigate these challenges and make informed decisions regarding their R&D expenses.

Complexities in Implementing the New Rules

Implementing the new Section 174 rules is complicated due to various factors. Taxpayers now have to determine which expenses must be treated as R&D and navigate the requirements for multiple parties involved in R&D activities. Questions arise regarding the capitalization of expenses in contract research arrangements and the treatment of software development expenses under Section 174.

Contract Research Arrangements

Determining Section 174 expenses in contract research arrangements can be challenging. While the party paying for the research can capitalize the costs paid to the contractor, it remains unclear whether the contractor performing the research must also capitalize their expenses. Factors such as technical uncertainty, risk-bearing, and rights to development or improvement may influence the determination of Section 174 expenses. Additional analysis may be required for contracts involving related parties, third-party funding, or the use of third-party equipment.

Software Development Expenses

The treatment of software development expenses under Section 174 raises questions for many taxpayers. While the new rules explicitly require the treatment of software development costs as R&D expenditures, the determination of whether specific expenses qualify depends on factors such as the complexity of the work performed, types of expenses incurred, and contractual arrangements. Taxpayers should document all activities and expenses related to software development to assess the need for capitalization under Section 174.

Section 280C Elections

Section 280C prevents taxpayers from claiming both the Section 41 research credit and a Section 174 deduction for the same expenses. Historically, taxpayers have had the option to make an election to take the entire Section 174 deduction and reduce the research credit. However, with the changes to Section 174, the interaction between Section 280C and the new rules is modified. Taxpayers need to reconsider their approach to Section 280C, as the benefits of making an election may vary based on individual circumstances.

Allocation of Indirect Costs

Indirect costs, such as overhead expenses and wages, are subject to Section 174 capitalization. However, there is limited guidance on which indirect costs specifically apply to Section 174. Taxpayers will need to evaluate the facts and circumstances related to their indirect expenses incurred in R&D activities and develop a reasonable method for allocating those costs. Documentation and careful consideration of indirect costs are essential for accurate Section 174 calculations.

Considerations for Mergers and Acquisitions

Companies involved in mergers and acquisitions starting in 2022 must consider the implications of Section 174. Given the limited guidance from the IRS, parties should negotiate and plan for potential changes to pre-closing tax liabilities. Questions regarding the sharing of tax liability changes, responsibility for filing amended returns, and the impact of Section 174-related adjustments on financial statements should be addressed during negotiations.

Section 174 and Software-Based Startups

Software-based startups face unique considerations regarding Section 174 and its impact on their operations. These startups heavily rely on software development for their products and services, making the treatment of software development expenses under Section 174 significant.

The new rules explicitly require the capitalization and amortization of software development costs as R&D expenses. For startups, this means that the costs associated with developing software must now be spread over a period of five or 15 years, depending on their nature.

The capitalization of software development expenses can have both financial and operational implications for software-based startups. Financially, it may result in increased taxable income in the current year, potentially affecting the startup's cash flow and ability to reinvest in further research and development. Operationally, startups will need to carefully track and allocate expenses related to software development to comply with the capitalization requirements of Section 174.

Additionally, software-based startups may also be eligible for the Research Tax Credit (RTC) under Section 41. While Section 174 encompasses a broader range of expenses than the qualified research expenses (QREs) used to calculate the RTC, startups should consider the interplay between these two provisions to optimize their tax strategies. Working closely with tax professionals can help startups navigate the complexities of Section 174 and leverage available tax incentives.

Conclusion

The recent changes to Section 174 have significant implications for companies engaged in R&D activities. Understanding the requirements for capitalization, the types of expenses that qualify, and the impacts on financial statements and tax liability is crucial for compliance and effective tax planning. Despite the implementation challenges posed by the new rules, taxpayers can navigate these complexities by consulting with tax professionals, carefully documenting expenses, and developing appropriate allocation methods. For software-based startups, the treatment of software development expenses under Section 174 requires specific attention to ensure compliance and optimize tax strategies. By staying informed and proactive, companies can effectively manage the changes introduced by Section 174 and position themselves for continued innovation and growth.

Traact is a comprehensive entity management software that can assist you in navigating through your tax and compliance requirements effortlessly. It can manage multiple entities across 150 countries, including their taxes. You can also select a registered agent for your entities, handle contracts, disputes, permits, and much more with Traact. Book a free demo to discover how to streamline corporate and legal functions with our platform.